Bond Credit Rating

A bond credit rating represents the credit rating agency's opinion on the likelihood of a rated debt obligation being repaid in time and in full. It is an assessment of the probability of the bond issuer’s default on payment of principal and interest. The bond issuer must mandatorily disclose the credit rating details in their prospectus, information memorandum or shelf prospectus once the credit rating has been obtained.

Each listed bond holds a rating provided by one or more Credit Rating Agencies (CRAs). A higher rating suggests a lower amount of risk involved and a lower rating indicates that the risk involved in the bond is higher.

The SEBI (Credit Rating Agencies) Regulations, 1999 or CRA Regulations, govern the credit rating agencies and provide the rules and regulations in regard to eligibility criteria for registration of credit rating agencies, requirements for a proper rating process, monitoring and review of ratings, inspection of rating agencies by SEBI, avoidance of conflict of interest and other things. Credit rating of debt securities, appointment of debenture trustees and separate listing agreement have been made mandatory to enhance the protection of investors in the bond market.

Investment Grade Bonds

Bonds carrying credit ratings of AAA to BBB are known as investment grade bonds. The credit rating of AAA refers to the highest degree of safety in terms of interest and principal repayment and BBB refers to a moderate degree of safety. These bonds are also known as low risk bonds, as their high credit rating leads the issuer to carry minimal default risk in terms of principal and interest repayments. Government bonds are also classified as low risk bonds due to the sovereign guarantee and therefore, offer the highest level of safety among all investment instruments.

Speculative Grade Bonds

Bonds carrying credit ratings of BB and below fall under the speculative-grade category, i.e., the ability of the issuer to meet the payment obligations is considered to be ‘speculative’ and therefore has a higher risk of default. These bonds are also known as high yield bonds (also known as junk bonds), as the issuer offers higher coupon rates to compensate investors for the higher risk involved.

Financial Performance of an Issuer

Credit rating is determined based on data and information available at a point in time with the rating agency. Any change in the financials of the issuer over time impacts the ability to repay debt levels and cash flow and therefore, ratings get altered. The ratings can be upgraded due to improved earnings, better cash flow, etc., or can be downgraded due to deteriorating liquidity or rising debt.

Economic & Regulatory Factors

Recession, changing consumer demand, or inflation are some economic factors that can alter the credit rating of the issuer. Regulatory changes within the industry or sector can also impact the issuer’s credit rating. Amendments in bond taxation policies can also significantly impact credit ratings by directly altering an issuer’s profitability, cash flow and debt-servicing capability.

Filtering bonds based on risk appetite

Bond credit rating is a preliminary check before investing, as it helps investors to filter out safer and riskier bond options. Conservative investors can focus on investment grade corporate bonds, i.e., AAA to BBB-rated bonds, for safety and capital preservation. On the other hand, aggressive investors can focus on speculative grade bonds, i.e., BB and lower, for higher returns.

Understanding the risk-yield trade off

A higher rated bond indicates a lower chance of default as it is issued by a strong financial company. But such bonds offer lower yields. On the other hand, lower rated bond indicate higher default risk as they are issued by companies having lower credit ratings, i.e., the ability to meet the coupon and principal is considered to be ‘speculative’. Because of this higher credit risk, lower rated bonds offer higher coupon rates to compensate investors for the higher risk involved. A mix of different credit ratings in a portfolio can help investors to strike the right balance between income and risk and help diversify across sectors and ratings.