Understanding Bond Credit Rating
Humans are unique creatures with an appetite to earn potential returns while ensuring safety from their investments. Investments like bonds, debentures, and other debt instruments fulfil these needs by providing market returns and prioritising credit repayment.
Among these, bonds are one of the most innovative instruments that may facilitate capital appreciation and interest income along with facets of security. However, understanding bond credit rating is crucial for determining the quality of your investments.
All About Corporate Bonds
Globally, bonds are one of the most sought-after investment instruments, with a market of $133 trillion1. It is a debt instrument issued by entities like businesses, banks and government to raise funds. Its features like principal redemption, interest income, market exposure and repayment priority make it an attractive investment avenue.
Corporate bonds – debt instruments offered by corporates – are gaining prominence due to their higher returns and low market exposure. However, like every instrument, these bonds are also accompanied by some risks concerning credibility, interest payment, liquidity and inflation.
Investors can decode the overall quality of corporate bonds, along with their credit risk factor, with the help of a bond credit rating. These ratings are based on several factors determined by bond rating agencies. Let us explore these ratings in detail.
Bond Credit Rating: A Brief Analysis
The creditworthiness of the issuer is indicated by the bond credit rating. In general, the higher the ratings, the lower the default risk. In corporate bonds, its ratings become crucial due to companies issuing them. Credit rating agencies determine the relevant criteria and allot a score to these instruments. The aggregate of these scores decides the bond credit rating.
Significance Of Bond Credit Rating
Checking the credit rating of a bond becomes a crucial factor in evaluating an investment. Bond credit ratings can help investors in the following ways:
- Bonds with higher ratings are preferred by investors. Therefore, credit ratings can indicate the potential liquidity of the instrument.
- Investors evaluating the different criteria may be prone to human error but a holistic approach of credit rating agencies can help simplify the process.
- Ratings play a crucial role in corporate bonds as the debt is a priority in repayment.
The companies analysing the bonds and issuing the rating are one of the key components of the bond rating mechanism.
Bond Rating Agencies
These entities play a crucial role in determining the bond credit rating based on several parameters that can comprehensively indicate its health. The criteria may differ based on the type of issuer, their fundamentals, fundraising objectives, investment psychology of rating agencies, the instrument tenure and many more aspects.
Globally, some of the famous rating agencies in the world are S&P, Moody’s and Fitch. In India, popular bond rating agencies are CRISIL, ICRA, CareEdge and India Rating and Research. The rating criteria of these agencies is a mix of several internal and external attributes. Here are some of the basic bond rating criteria commonly used by the rating agencies:
- Operational efficiency of the business with quantitative models that may differ by rating agency.
- Debt repayment and operating lease adjustments.
- Valuation of the security and companies issuing them.
- Regulatory discipline and environment.
- Sector and country analysis through measures like sovereign default risk and country risk.
Understanding how these different criteria sum up to a credit rating can help investors interpret the rating scales.
Bond Rating Scale And Categories
The rating by agencies can help investors differentiate between the different categories of corporate bonds based on their quality. Here is the rating chart of some of the common firms where the AAA scale is the highest, followed by ratings of B, C or D.
Bond Rating Agencies | Investment grade | Speculative grade |
S&P Global (CRISIL is S&P Global company in India) | AAA, AA, A, BBB, BBB- | BB+, BB, B, CCC, CC, C, D |
Moody's Corporation
| Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3 | Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C |
FitchRatings | AAA, AA, A, BBB | BB, B, CCC, CC, C |
ICRA | AAA, AA+, AA, AA-, A BBB, BB | B, C, D |
Investors can interpret these ratings with respect to creditworthiness. For example, the highest rating of AAA or Aaa indicates a strong safety level and timely management of debt obligation. This creditworthiness decreases with further ratings in the order.
Many aspects regarding the issuing company, asset quality, credit risk, and more are differentiated when bonds are categorised into investment grade and speculative (also known as junk or high-yield bonds) grade.
Investment Grade Bonds Vs Non-Investment Grade Ratings Bonds
Particulars | Investment grade bonds | Non-investment grade bonds |
Definition | These are bonds with considerable high ratings, indicating a strong capacity for managing debt. | These are with low investment quality and significant chance of credit default by the issuer. |
Ratings | They are the bonds with higher ratings, usually between AAA and BBB. | Due to their lack of credibility, their ratings are lower, usually between BB to C or D. |
Yields | Ratings are based on risk. Therefore, highly rated bonds have low risk and returns to protect the investors. | Here, the risk associated is high, which attracts high yields. |
Liquidity | Generally, firms issuing these bonds are stable and high ratings enable easy sale in the market. | The lower rating discourages investors from buying such bonds. It may be less liquid. |
Income | It may provide stable interest income, but capital may appreciate at a slow pace. | Interest income may be volatile. However, higher market yields may help appreciate capital. |
Impact of Bond Credit Rating on Investors
The bonds are different from regular investment instruments and may be perceived as complex by investors. However, they offer a unique diversification to the portfolio. Investors willing to invest in corporate bonds may have to analyse different aspects regarding the company, its operations, capital structure, valuations, risk factors, and so on. It may complicate the process and discourage the investors.
In such a scenario, the bond credit ratings can help understand the investment quality in a simplified way. On Grip, almost 21% of the total corporate bond investments were in AA or above rated bonds. Therefore, bond ratings are crucial for timely investment decisions.
Does A High Rating Guarantee A Safe Bond Investment?
Bond investments are dynamic, and credit is not the only risk for them. Therefore, only a high credit rating may not guarantee a safe bond investment. High ratings may be prone to low returns due to less risk. In such a scenario, the interest risk may always hover over the investments. Investors should analyse the probable bond investment holistically and credit rating can be one of the crucial tools for the same.
Advantages And Limitations of Credit Ratings
Advantages
The bond credit rating can benefit its stakeholders in gauging the credit default risk. Investors can use the credit rating to diversify their investments. The efforts and time required to analyse varied aspects can be reduced with the help of such ratings. Moreover, investors may get a view of the potential yields or liquidity of the bonds.
Disadvantages
The methodology used by bond rating agencies may hinder the process with their subjective models and criteria. The rating analysing historical performance may not be accurate for future predictions.
Summary
Corporate bonds are gaining popularity in India due to their features of interest income and debt market exposure. However, before investing in them, investors should determine their quality with the help of bond credit ratings. They are an efficient tool to gauge the risk profile of an investment. Investors can understand the bond rating scales and categories, analyse their risk appetite and make the investment decision.
So, are you ready to dive into the world of corporate bonds? Sign up to Grip and explore a wide range of 30+ corporate bond options!
Frequently Asked Questions About Bond Credit Rating
1. Which are the credit rating agencies in India?
Bond rating agencies are entities that analyse the investment quality and risks for assets through comprehensive analysis. In India, some of the popular credit rating agencies are CRISIL, ICRA, India Rating and Research and Care Edge.
2. What is the difference between investment grade bonds and junk bonds?
The investment grade bonds are highly rated bonds based on credit default risk. On the other hand, junk bonds have comparatively low ratings. The main difference between them is sensitivity to market volatility, interest rate risk or inflation risk. Compared to investment grade, junk bonds are sensitive and can become junk if a company defaults on its repayment.
3. What is the difference between investment grade bonds and high-yield bonds?
High-yield bonds have a low credit rating compared to investment grade bonds, which indicates high risk. However, the increase in risk may also increase returns. Therefore, low-rated bonds (high-yield) may generate potential returns compared to investment grade bonds.
References
1. WEF, Accessed from https://www.weforum.org/stories/2023/04/ranked-the-largest-bond-markets-in-the-world/
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