How bond ratings impact investment decisions

Credit ratings are like those grades teachers give in school to evaluate students’ performance. Credit rating agencies check on the strengths of companies issuing the bonds and grade the bonds accordingly - such as AAA for highest safety to D for likely to default. This helps investors gain a better understanding of the quality of the bonds and take investment decisions accordingly.

Bonds, as we know, are issued by companies and governments, to borrow from the public, promising repayment at a certain interest rate (called coupon rate, in the world of bonds) at the end of an agreed timeframe/tenure (on 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. Even so, it is critical for investors to be guided in their pick by the credit rating assigned to the bonds, based on their creditworthiness, cash flows, borrowings, repayment history and the performance of the business of the issuing company.

There are agencies such as Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency (ICRA), Credit Analysis & Research Limited (CARE) and a few more, that evaluate and grade the bonds.

Factors weighing in

Credit risk: In the world of investing as a general principle, risks and rewards are positively correlated. So if you invest in an instrument with higher risk, you could end up with higher returns and the less risk you take the less you may earn from it. 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 study how likely the bond issuer will be able to pay back the money they owe, and rate the bonds accordingly. 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. 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. 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. In short, you will be paying more to earn the same coupon rate. A high rated bond usually attracts more buyers, pushing its price up in the secondary market, cutting down its yield.

Interest rates on other investments: The interest rates on other investments also impact the investment decisions of investors. For example, if an AAA-rated bond offers a return of 9 per cent when other debt investment like FD offers 8 per cent, the bond becomes more attractive, leading to increased demand and a potential rise in its price. Mark that in the secondary bond market the comparison will be between the yield on the investment in other instruments and that of the bonds (rather than the coupon rate offered).

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.

(The writer is Vice President- Research, Teji Mandi)