Question

1. Discuss bond credit ratings. What are the two basic categories of bonds according to their credit rating (you do not need to refer to specific ratings) and what is the credit spread?

Answer 1

Bond Credit ratings are simply put, the credit ratings assigned by Credit Rating Agencies/ Institutions which signify the safety, investment level security of the bond. These credit ratings are given by the rating agencies after taking into consideration complete financials of the company under consideration. The credit ratings hence determine the interest rate which would be offered by the particular bond. i.e. Bonds with higher credit rating would typically offer lesser yield than bonds with a lower credit rating. This is because the issuer of a bond with a higher credit rating has a lower chance of defaulting on the bond payments while the issuer with a lower credit rating has to compensate the investor for the higher risk that the investor would be taking by investing in the bond through higher interest rate.

Two basic categories of bonds according to their credit ratings are:

1. Government Bonds - These are bonds which are issued by the Central Government. There may be different maturities for bonds of this kind. It may range from 91 day Treasury Bills to Long Term bonds having maturities in years.Government Bonds typically have the highest credit rating because of the thing that a country's Central Government has the lowest chance of defaulting. This is because if a Central Government defaults then it would mean that the country would be on the verge of a financial meltdown.

2. Corporate Bonds - These are bonds which are issued by the Corporates/Companies. These bonds are issued by the company to raise capital for working of the company. The bonds issued by Corporates/Companies may also be entrusted with the highest credit rating if the company under consideration is financially robust and has good liquidity and cash flows. However if the Credit Agencies feel that that the company's financials are not so robust then it may be given a lower credit rating as compared to the government bonds.

Credit spread is simply put the difference between the Treasury Bond (Government Bond) and Corporate bond of the same maturity but different credit quality.
Example - If a Treasury Bond of 10 year maturity is giving a yield of 7% whereas a Corporate Bond of 10 year maturity is giving 8.5% yield. then the Credit Spread is 8.5% - 7% = 1.5%.