What Are Credit Ratings And How It Impacts Bond Prices: Here's A Quick Guide

With growing interest in the market towards investing in safer assets, interest in debt securities has increased. While bonds are a safer and more conservative instrument compared to equities as they give a fixed return, it becomes important to understand that risks in bonds differ depending on the issuer, tenure, among other things.

India has nearly a Rs 300 lakh crore deep debt market, and as regulators push for more depth in the market, it becomes necessary to understand the credit ratings of a company and the nature of the securities.

What is a Credit Rating

Credit ratings assess the credit worthiness of a company, similar to how an individual’s Cibil score determines an individual borrower’s creditworthiness and loan approval. Credit ratings agencies analyse various factors to assess the credit risk of the company and accordingly, assign a grade to the company, which shows its ability to repay or probability of default.

Companies are rated according to their past performance, the debt to growth ratio, and other metrics to gauge the risk associated with company while issuing bonds. Credit ratings of a company is an indication of its ability to pay back the debt.

Credit ratings agencies analyse various factors to assess the credit risk of the company. This includes the debt levels, economic and industry environment in which the company operates, and so on. Accordingly, these credit ratings agencies assign a grade to the company, which shows its ability to repay or probability of default. These ratings are monitored and revisited by the ratings agencies from time to time, which could also lead to the company being upgraded or downgraded depending on the financial and economical position.

A and above ratings, such as AA, AAA indicate the highest credit quality of the borrower. These grades show the lowest risk association with the borrower, which makes it safer for investors to invest in them. Accordingly, B or C ratings of a company indicate a comparatively higher risk with a higher probability to default.

Credit ratings and bond prices

The credit risk of a borrower translates to bond prices and yields. The higher the risk of investment, the higher will be the demand from investors for higher yields. Ratings and bond yields have an inverse relationship – the higher the credit rating, the lower the bond yield. Higher credit risk means a potential loss for investors if the bond issuer is unable to repay either part or full of the interests and principal payments. The higher yield in this case compensates investors against the higher chance of defaulting on the borrowing.

Now, even if the credit rating of the company at the time of issuance of the bond was lower but was upgraded due to some structural changes, the outstanding bond which was issued before the upgradation will change the price and yield in the secondary market based on the update.

Liquidity of a particular bond will also differ depending on the risk, gauged by the credit rating of the bond. These ratings could also change depending on the tenure of the bond. Longer tenure bonds are generally considered riskier than shorter tenure bonds, as it takes a longer time for repayment, during which market conditions and the company’s position in the industry could change. Similarly, the liquidity of a bond in the secondary market, that is, the ability for an investor to freely buy or sell a particular bond, will depend on the risk appetite in the market and the credit worthiness of the company and the bond.