How Bonds Rating Works?

Bond ratings reflect credit quality and the associated risk of a bond issue. Ratings are given by rating firms such as CRISIL, Care, and ICRA in India. The firm assesses the financial strength of the bond issuer and its capability for repayment of the funds. The range of ratings starts from “AAA” for bonds with the highest credit quality and low credit risk; bonds carrying a higher risk of default are classified as “B-” and below. The rating will help investors estimate the security of their investment since higher-rated bonds are linked to more security but yield lower compared to bonds with a low rating that are much riskier.

Key Takeaways

• The rating of the bond refers to the creditworthiness of the issuer and ranges from AAA, the highest, to D, defaulted.

• Major rating agencies like CRISIL, CARE, and ICRA do ratings in India to guide investors on the risk associated with bonds.

• Investment-grade bonds would fall from AAA to BBB, carrying with them relatively low risk and therefore stability, while non-investment-grade bonds would range from BB+ to D, carrying higher risks and possible rewards.

• These ratings depend on various factors that include the financial health of the issuer, trends within the industry, and general economic conditions.

Rating Bonds

Bond ratings depend on internal and external factors. Internal factors involve the study of the issuer’s financial health through financial statements and ratios, including debt levels, profitability, and cash flow, among others. Externally, the credit rating firms assess factors like support to the issuer from its parent company, government backing, and economic conditions prevalent in the country. Agencies also look at the industry to which the issuer belongs and its market environment. All these will culminate in an overall rating that would give the investor an idea of the clear credit risk of the bond.

How do Bond Ratings Work?

The bond credit rating ranges between AAA and D, which indicates the financial strength of the issuer. The highest rating is AAA, while D refers to default. In India, the major agencies that grant credit ratings to bonds are CRISIL, CARE, and ICRA. Bonds, as per ratings, fall either into investment grade or into non-investment grade.

 Investment-grade bonds are those bonds that have ratings between AAA and BBB. These bonds are considered safer and a more secure form of investment because of the better financial standing of the issuer.

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In contrast, non-investment-grade bonds, also called high-yield bonds, rated from BB+ to D, are riskier but offer more return because of the greater risk undertaken. Such bonds are expected to be issued by small firms, startups, or companies that have limited operational diversity. Rating agencies do periodic rechecks of bond ratings. Sometimes an investment-grade bond loses its quality, thereby getting downgraded into a non-investment-grade rating; in such instances, the bond is called a fallen angel bond.

Investment Grade Bonds

An investment grade is a rating given to a municipal or corporate bond indicating that it has a relatively low risk of default. Among bond rating companies, such as CRISIL, CARE, and ICRA, an assortment of the upper- and lower-case letters “A” and “B” show the credit quality rating of a bond.

“AAA” and “AA” (high credit quality) and “A” and “BBB” are considered investment grade.

Junk Bonds

Non-investment-grade bonds, or “junk bonds,” are usually rated from “BB+” to “D” or “not rated.” Bonds in these grades are viewed as higher credit risk, thus making them attractive for investors seeking higher yield. An investor in junk bonds needs to take into consideration the risks of investment in bonds issued by companies with liquidity issues.

• Fallen Angel: An investment-grade bond that has fallen to junk-bond status due to the poor credit quality of the issuer.
• Rising Star: The opposite of a fallen angel, this is a bond whose rating has been increased due to improving the credit quality of the issuer. A rising star may still be a junk bond but is on its way to investment quality.

Factors That Affect Bond Ratings 

Bonds are debt instruments that governments and corporations, as well as other entities, issue to raise finance for their operations. The rating on bonds is a measure of the creditworthiness of the issuer and gives investors some idea of the risk involved in investing in a particular bond. There are several influences on the rating of bonds, and in this section of the article, we will take a closer look at some of the most important ones.

1. Financial Position

An issuer’s financial position is the most critical credit factor affecting bond ratings. Bond rating agencies look into an issuer’s financial statements and judge the capability of the company to generate cash flows and pay off debts. Further, they assess the liquidity, profitability, and leverage ratios of the company to gauge it. The ranking will be high in the case of a company having a sound financial position and, low in the case of a firm having a weak financial position.

2. Economic Conditions

The economic condition prevailing in the country where the issuer is operating affects the ratings of bonds. It would automatically affect the bond ratings of the issuers if the country is in a recession or financial crisis. This is because the economic conditions may affect the ability of the issuer to generate cash flow and, therefore, repay its debt. Also, economic conditions influence demand for the products or services of the issuer and, thus, affect the issuer’s revenues.

3. Industry Trends 

The trends of the industry in which the issuer operates also tend to affect the ratings. A rising industry from which the issuer is performing well will enhance that bond’s rating. In a decline, the reverse would occur if the industry is going down and the issuer is not performing up to par; then, its bond ratings would fall.

4. Management Quality

The other prerequisite that becomes important in determining bond ratings includes the management quality of the issuer. In this regard, bond rating agencies consider the track record of the management team concerning experience and execution of a business plan. A strong management team with a good track record for the execution of business plans results in higher ratings on bonds.

5. Regulatory Environment

The regulatory environment in which the issuer operates can also impact its bond ratings. For instance, an issuer who belongs to a highly regulated industry may face fines or other penalties for non-conformity with regulations, and these things can affect cash generation and debt service.

6. Political Environment

These are conditions that can also be referred to as the political environment in which an issuer operates. For example, in the case of political instability or uncertainty, it might affect an issuer’s ability to operate and generate cash flow, thus affecting bond ratings.

Some of the factors affecting bond ratings include the financial position of the issuer, prevailing economic conditions, industrial trends, quality of management, regulatory environment, and political environment. All these factors should, therefore, be looked into by investors while assessing the creditworthiness of an issuer in making investment decisions. Indeed, a detailed, comprehensive study of those factors would allow one to make better and more informed investment decisions. 

Conclusion

The ratings of the bonds predominantly determine the creditworthiness of an issuer and the risk inherent in a bond. These ratings by agencies like CRISIL, CARE, and ICRA help investors assess the financial strength of the bond-issuing firm and the probability of receiving timely interest and principal repayment. For example, high AAA ratings expose the risk to be low and safer investments. The lower it is rated, the higher the risk and possibly a higher return on investment. Investors shall remember some specific internal factors and external factors that may influence the rating of bonds: the financial status of the issuer, the trend in the particular industry a firm belongs to, and the general state of the economy as a whole. By understanding these conditions, investors will be able to make sound decisions and avoid unnecessary risks when making investments in bonds.

FAQs on Bonds Rating