Question

Explain why you would different rates of return on bonds rated at different categories by rating agency – and how much a shift in the ratings would make. Explain what other factors affect the perspective of risk of a particular bond investment

Answer 1

Answer:

Credit rating agencies rate bonds on muliple categoies: e.g. for Standard & Poor's rating parameters are AAA (Highest rating) , AA, A, BBB, BB, B, CCC, CC, C, and D, with the latter denoting lowest grade of rating.

Rating agencies consider multiple factors while rating a bond:

1. Industry risks that bond issuer is facing or may face in the future
2. Market position of the bond issuer
3. Management qualtity, strategy, risk tolerance, policies etc.
4. Corporate Governanace standards, boards effectiveness and independence,
5. Accounting policies and transparencies
6. Company profitability, cash flow position,capital structure etc.

After considering and rating the bond and bond issuing company, the rating agencies give an opinion about the issue by terms of their Ratings. Hence bonds with different rates of returns are rated under different categories. Generally highest rated bonds AAA comes with lowest returns and D rated bonds, also called as junk bonds comes with highest returns, because of the risk return parameters.

Ratings assigned to a bond issue is not permanent. It's been evaluated from time to time. Any improved or favourable condition on any parameter discussed above might results in an up-grading of a bond and vice-versa. So a shift in a bond rating denotes are change in the risk - reward equation of the issue.

Other factors that the bond investors consider while making an investment in a bond issues are:

1. Interest rate risk: the likely hood on interest rates going up and down in the future, which impact the value of the bond issue.
2. Inflation risk: increase in inflation will result in decrease in the relative value of the bond issue.
3. Reinvestment risk: where the bond holders doesn't have enough avenues to reinvest the premium received. In this case they'll perfer zero coupon bonds.
4. Call risks of bonds: this applicable in case of callable bonds only, where the company has an option of calling bonds earlier than their maturity time. This'll also impact the value of the bonds.

Do let me know in case of any doubt.