Question

What might be the problem if we rely on a change in credit ratings by rating agencies (e.g. S&P, Fitch, Moody's) to infer any change in default risk of a corporate bond? (3 sentences)

Answer 1

PROBLEMS THAT MIGHT OCCUR IF WE RELY ON CREDIT RATING AGENCIES

1) There might be a sudden recession or boom in the economy due to some uncontrollable factors that the rating agencies might not have predicted and the potential company that one has invested in gets severely effected therefore defaults in payment. So the investor looses his funds and interest to be received(not for zero coupon bond )

2) A change in credit rating of a corporate bond regarding its risk might indicate that the bond is not doing well currently and the investor might choose to sell it at a lower rate and suddenly the bond might perform well so invester incurs a loss.

3) Credit ratings is just an approximate rating of a company or an financial instrument and they might not neccesarily perform as per the rating so the investor looses on the opportunity cost of an investment.That is the investor might have gained more by investing the same funds in some other company or bonds performing better in the economy. Also Funds in the bond get locked up for a specific period of time.