Understanding Credit Ratings: How Bond Ratings Impact Investment Decisions!

Understanding Credit Ratings: How Bond Ratings Impact Investment Decisions!

Find out how bond ratings and yields shape your investment decisions.

Back in school, remember how teachers used to show our grades to our parents and let them know if we were doing well or needed to improve? Well, in the world of bonds, the situation is similar. Instead of teachers, there are Credit Rating Agencies. Their job is to check out how well companies that issue bonds are doing financially. Then, they give a grade to each bond, like AAA (highest safety) to D (likely to default), so investors who want to invest money can understand how good or not-so-good the company is.

Now, these grades, or ratings, are significant. They can affect both the company and your investment choices. Let’s find out how. 

What Are Bonds and Credit Ratings?

Bonds are a type of financial agreement. When companies or even the government needs money, they can ask investors like us to lend them money by investing in their bonds. In return, they promise to pay us back with a set amount of interest (called coupon rate in the world of bonds) and give us our money back when the agreed time is up (maturity).

Investors regard bonds as a reliable investment option since they can get regular coupon payments at defined intervals and the full principal amount upon maturity. This makes bonds an attractive investment option for investors to park funds.

But, before investing, every investor checks one thing in common – the credit rating of the bond. 

Now, what is a credit rating? It is the grade they get based on their creditworthiness, cash flows, borrowing and repayment history, and the performance of the business of the issuing company. 

These grades are given by prominent credit rating agencies, which include Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency (ICRA), Credit Analysis & Research Limited (CARE) and a few more. 

How Bond Ratings Impact Investment Decisions?

Credit Risk

In the world of investing, there is a general principle: the more risk you are willing to take, the greater the potential rewards. This means that if you decide to invest in an investment that carries a higher risk, you might end up with a higher return on your investment. 

The opposite is also true – if you invest with less risk, you get less returns. 

When a company or a government wants to borrow money by issuing a bond, there is a concern about whether they can repay the money they owe. This is called credit risk.

Credit rating agencies are like financial experts who study how likely the bond issuer will be able to pay back the money they owe, and hence ratings are given. 

If a bond gets a high rating like ‘AAA’, the issuer is very good at managing their debts and has a very low chance of default. This makes these bonds very attractive to risk-averse investors. But, with safety comes fewer returns, so these bonds offer low coupon rates. But, investors are willing to accept lower earnings because they feel secure about getting their principal amount back.

On the other hand, if a bond gets a lower rating like ‘BB’, ‘B’, or ‘C’, it means the issuer might have a harder time paying back what they owe. This makes these bonds riskier to invest in. Investors who invest in these bonds want to be compensated for taking on that extra risk. So, the bonds offer a higher coupon rate, which means investors can potentially earn more money, but they are also taking a higher risk that they might not get all their money back.

Yield in Secondary Markets

After companies issue bonds, these bonds are often traded on the secondary markets. This is where investors who didn’t get a chance to buy the bonds when they were first introduced get an opportunity to buy. Also, investors who want to sell their bonds before they mature can find buyers.

In the secondary markets, the perception of people drives change in prices. Similar is the case of bonds. If many people want to buy a particular bond because they think it is a safe investment, the demand pushes the bond’s price up. This often happens with bonds having higher ratings. 

And here is where it gets interesting: when the price of a bond goes up, the interest it pays (coupon amount) stays the same, and hence, the current yield goes down. 

Let’s use an example to understand better. Imagine there is a bond that is rated safe (AAA), and it’s worth Rs 1,000. It gives you a 10% coupon (Rs 100 every year as interest, and the bond will mature after ten more years. 

Now, because so many people want to buy this safe bond, its price in the secondary market goes up to Rs 1,200. But remember, it still only gives you Rs 100 every year.

So, if you do the math, the percentage you get from your investment (the yield) goes down. Before, it was 10% (100/1000), but now it’s about 8.33% (100/1200). 

You can calculate the yields here – https://investor.sebi.gov.in/calc/calculators.html  

A higher rating for a bond usually makes more people want to buy it, which can make the price go up and the yield goes down.

Conversely, lower-rated bonds might struggle to find demand in the secondary market. This prompts issuers to set higher coupon rates to entice investors with greater returns for taking higher risks.

Interest Rates on Other Investments

The interest rates on other investments also impact the investment decisions of investors. For example, an AAA-rated bond offers a return of 9% when other debt investment like FD offers 8%, and the bond becomes more attractive, leading to increased demand and a potential rise in its price. 

But note that rising prices can then cause coupon rates to decrease. 

On the contrary, if a bond’s coupon rate is lower than market rates, its attractiveness diminishes, leading to reduced demand and a potential decrease in its price. Falling prices might result in higher coupon rates.

In conclusion, the relationship between bond ratings and coupon rates is fundamental to the bond market. Bond ratings, assigned by credit rating agencies, serve as indicators of an issuer’s creditworthiness and default risk. These ratings influence investor perceptions, market demand, and pricing dynamics. 

As an investor, understanding how bond ratings impact coupon rates is essential to make informed decisions in the dynamic landscape of the bond market.

*The article is for information purposes only. This is not an investment advice.

Note: This article was originally written by Teji Mandi for Deccan Herald.

Read the article here. https://www.deccanherald.com/business/economy/how-bond-ratings-impact-investment-decisions-2654926

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