Question

How does change in a corporate bond rating change investor’s required rate of return?

What actions could the company take to receive a rating upgrade?

Answer 1

In order to understand the impact of credit rating on bond investor's required rate of return, we must take a look at the following related points:-

• Bonds' yields are benchmarked on the interest rates in the economy. Since, the benchmark interest rates are risk-free, the required yield for a bond issue is calculated after taking into account the risk profile of the bonds.
• In other words, the yield that a bond is expected to offer is simply risk free interest rate, as adjusted per the risk profile of the bond.
• Therefore, the single most important factor (other than risk free rate offcourse) that determines the required rate of return for a bond is the risk the bond carries.

Change in required ROR in response to change in corporate bond rating

The investors generally rely on credit ratings by Rating agencies such as Moody's, S&P, Fitch in order to gauge the risk in a corporate bond. These ratings essentially classify the bonds with regards to risk of default in their interest or repayment on maturity.

The better the rating, the lower the risk in a bond and vice-versa. E.g.- AA rated bonds are considered to be very safe while B rated are considered very risky.

As the bond rating change, it directly changes the investor's perception of the underlying risk in the bond and hence his required rate of return. When a corporate bond rating is downgraded, the risk goes up and investor's required rate of return goes up. When a rating is upgraded, the perceived risk goes down the required rate of return on the bond goes down accordingly

Actions a company could take to get a rating upgrade

Since the bond ratings are based on the underlying risk of the bonds, a rating upgrade happens when there is a positive change in underlying fundamentals of the company that reduces the risk to its debt liabilities. Few examples of actions that a company can take to get a rating upgrade are as follows:

• Diversification into different businesses (rather than all eggs in the same basket) which may reduce the overall operating risk of the company
• Divestment of high-risk business segments or the segments that generate low returns on capital and drag the financial performance of the company
• Create an optimum capital structure between equity, debt and preferred stock to reduce the financial risk of the company
• Effective alllocation of capital, i.e. investment in projects that offer high returns on capital
• Achieving durable competitive advantages in its industry, which will reduce the operating risk and increase the certainty of its operating cash flows
• Merger or acquisition with a suitable partner/target may bring in synergies as well as reduce the underlying risk to its debt liabilities
• Bringing in cost efficiencies, improving margins and the overall financial performance of the business