Understanding ratings of Corporate Bonds

Corporate bonds are categorized by credit quality. Credit Rating agencies such as CRISIL, CARE, Brickwork provide independent analysis of corporate bond issuers, grading each issuer according to its creditworthiness. Corporate bond issuers with lower credit rating tend to pay higher interest rates or ‘coupon rates’ on their corporate bonds.

Here is the Credit Rating Scale of CRISIL.

AAA (Highest Safety) – Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk.

AA (High Safety) – Instruments with this rating are considered to have a high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.

A (Adequate Safety) – Instruments with this rating are considered to have an adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk.

BBB (Moderate Safety) – Instruments with this rating are considered to have a moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk.

BB (Moderate Risk) – Instruments with this rating are considered to have a moderate risk of default regarding timely servicing of financial obligations.

B (High Risk) – Instruments with this rating are considered to have a high risk of default regarding timely servicing of financial obligations.

C (Very High Risk) – Instruments with this rating are considered to have a very high risk of default regarding timely servicing of financial obligations.

D (Default) – Instruments with this rating are in default or are expected to be in default soon.

How are corporate bonds priced?

The price of a corporate bond is influenced by several factors, including maturity, the credit rating of the company issuing the bond and the level of interest rates. The yield of a corporate bond fluctuates to reflect changes in the price of the bond caused by shifts in interest rates and the market’s perception of the issuer’s credit quality. Most corporates typically have more credit risk and higher yields than government bonds of similar maturities. This divergence creates a credit spread between corporates and government bonds so that the corporate bond investor earns extra yield by taking on greater risk. The credit spread affects the price of the bond and be graphically plotted and measured as the difference between the yield of a corporate and government bond at each point of maturity.

Why invest in corporate bonds?

Corporate bonds offer a range of potential benefits including:

  1. Diversification: Corporates offer the opportunity to invest in a variety of economic sectors. Within the broad spectrum of corporates, there is a wide divergence of risk and yield. Corporate bonds can add diversification to an equity portfolio as well as diversify a fixed income portfolio of government bonds and/or other fixed income securities.
  2. Income: Corporates have the potential to provide attractive income. Most corporate bonds pay on a fixed semiannual schedule. One expection is zero-coupon bonds, which do not pay interest but are sold at a deep discount and then redeemed for full face value at maturity. Another exception is floating-rate bonds that have fluctuating interest rates tied to a money market reference rate. These tend to have lower yields than fixed-rate securities of comparable maturities but also less fluctuation in principle value.
  3. Higher yields: Corporates tend to provide higher yields than comparable maturity government bonds and bank term/deposit interest rates.
  4. Liquidity: Corporate bonds can be sold at any time prior to maturity in a large and active secondary trading market through Smest.

What are the risks?

Corporate bonds are exposed to an interest rate rise. In addition, corporate bonds also have a credit or default risk – the risk that the borrower fails to repay the loan and defaults on its obligation. The level of default risk varies based on the underlying credit quality of the issuer.



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