The bond price falls when bonds are downgraded (that is, when the credit rating is dropped). The price rises if the rating is improved. In reality, bond values can fluctuate if there is even a remote chance of an upgrade or downgrade. This is because nervous investors sell bonds with deteriorating credit quality and acquire bonds with improved credit quality.
Price fluctuations in response to upgrades or downgrades, on the other hand, are significantly less significant than those caused by changes in interest rate levels unless there is a serious risk of default. Ratings move up or down one notch on the rating scale, and prices move up or down by 1 percent or 2 percent each bond in reaction to rating changes, with few exceptions. The price change refers to the amount required to bring a bond’s yield (and thus its price) in line with that of other bonds rated at the same level. For AA-rated bonds, for example, a downgrade to A+ may not result in a significant price difference.
This issue should be stressed since many private investors are overly concerned about modest downgrades, and the financial press can increase this fear. A decrease in the rating is not a major cause for concern for bonds with very high credit quality (AA or AAA). It would not result in a significant drop in the bond’s price. A series of downgrades, particularly if the credit rating falls below investment grade, would be a more serious problem.
The above propositions have one notable exception. Because of the prospect of downgrades due to takeovers, corporate bond prices were extremely volatile during the 1980s takeover craze.
Here are some common investor worries concerning bond credit ratings, along with their answers:
Certain downgrades, on the other hand, are more important than others and should be treated as red flags:
That isn’t always the case. The agencies’ grading scales are extremely conservative. Differences in rating levels are frequently dependent on nuances. Even after a downgrade, any bond rated investment grade or higher has good margins of safety.
If any of these things happen, you should think about whether you still want to purchase that security.
My bonds are insured, AAA-rated, or guaranteed by the government. Isn’t that going to ensure that the principal is safe?
No. Interest payments will be made on time, and the bond’s principal will be redeemed in whole at maturity. There is no link between that guarantee and the price (or value) of bonds as a result of interest rate variations. Interest rate changes influence all bonds, even those issued by Fly-by-Night airlines and those issued by the United States government. The value of your bonds will decrease as interest rates rise. The value of your bonds will increase if interest rates fall. Period. There are no exceptions.
Junk bonds, which are defined as bonds rated below investment grade, have a higher default rate.
It’s worth noting, though, that even when bonds default, bondholders rarely lose their entire investment. Bonds that have defaulted usually have some salvage value. Bonds issued by failed or bankrupt issuers are subject to a lot of speculation. This is due to the fact that such bonds can be purchased for as little as 10 to 30 cents on the dollar. Many defaults have resulted in coupon payments being suspended. Bonds in this category are believed to be trading flat. If coupon payments are restarted, the bond’s price might skyrocket. The selling of assets of issuers in bankruptcy proceedings may also benefit bondholders. Finally, some insolvent companies emerge from bankruptcy successfully, resulting in a windfall for everybody who bought bonds when the company was in default.
In terms of default risk, there is a scale. Any bond that is a direct liability of the United States government is considered to have no chance of defaulting. Federal agency bonds, as well as most types of mortgage-backed securities, are considered to be of almost comparable credit quality. Municipal bonds are rated in a wide range of ways, although they always have low default rates. Corporate bonds, in particular “junk bonds,” are significantly less predictable. And so-called developing market debt is extremely speculative.
Of course, it depends on the sort of bond in question. However, default rates are rather low if you just consider bonds with a credit rating of at least investment grade. Despite a few well-publicized defaults in the business sector since WWII, no bonds that are currently rated AA have ever defaulted. Bonds with an A rating have only seen two defaults. Municipal bonds have similar data. (While some bonds with high initial ratings subsequently defaulted, they were downgraded prior to the default.) As a result, it’s a good idea to keep an eye on the ratings of the bonds in your portfolio.)
I want to make as much money as possible while remaining as safe as possible. My broker suggests that I buy AAA-rated 30-year bonds and hold them until they mature. Isn’t that the safest course of action?
Bonds with maturities of five to ten years, rated at least investment grade or somewhat higher, are usually safer to buy if you are concerned about the safety of your principle and predictable income (depending on your preferences and tolerance for risk). You won’t be sacrificing revenue because the interest income from these bonds is likely to be comparable to (and often even higher than) that of AAA-rated bonds with extended maturities. However, the danger to the principal is significantly reduced.
Certainly not. This can be an expensive and risky method. It is expensive because AAA-rated bonds have lower yields than lesser-rated bonds with identical maturities. As a result, you are sacrificing money. It’s also dangerous for two reasons: One is that, as we’ve just shown, interest rate risk is much higher for longer-term bonds. If you must resell your bonds before they mature, you may be forced to accept a significant loss in principle. Furthermore, it is difficult to forecast how much you will earn on bonds with the longest maturities because reinvestment rates on interest income vary widely.
No. Keep in mind that ratings are just that: personal opinions. Actual debt service payments, which are made by the issuer, are not connected to the rating agencies. The ratings are also not intended to be a recommendation to purchase or sell a particular security. A low rating does not imply default, and a good rating does not guarantee anything, even the avoidance of a downgrade.
Is bond pricing influenced by ratings?
The bond grading procedure is crucial since it informs investors about the bond’s quality and stability. That is to say, the credit rating has a significant impact on interest rates, investment appetite, and bond price. Furthermore, ratings are assigned by independent rating agencies based on future expectations and prognosis.
What is the meaning of a bond rating?
A bond rating is a letter grade that shows the creditworthiness of a bond. These evaluations of a bond issuer’s financial health, or its ability to pay a bond’s principal and interest on time, are provided by independent rating services such as Standard & Poor’s and Moody’s.
How does the bond rating of a corporation effect the bond’s yield to maturity?
Triple-A is the highest quality rating. Issuers with lower-graded credits must pay a higher rate of interest than corporations whose bonds are rated investment-grade to tempt investors and compensate them for the associated risks. As a result, investors receive a higher “yield.”
What effect do bond ratings have on the cost of financing for the issuing company?
Due to the decreased risk involved, a high-rated issuer will pay substantially lower borrowing costs, as indicated in the interest rates charged, than a low-rated issuer. As a result, an investor can expect a higher return in exchange for the higher risk associated with low-rated debt. Lower-rated bonds would often have a higher coupon ratethe annual payments from the issuer to the investor as a percentage of the bond’s value on the day it was first issuedthan higher-rated debt. Consider that, as of mid-April 2019, yields on low-rated high-yield debt averaged roughly 3.7 percent, while yields on investment-grade debt with similar duration to maturity averaged less than 1.2 percent. 2
The government’s debt is rated near the top of the rating agencies’ scales, thanks in part to the government’s promise to back its borrowing with its “full faith and credit.” As a result, government debt often provides lower returns than comparable debt in the business market.
What influences bond prices?
The yield, current interest rates, and the bond’s rating are the most important aspects that influence the price of a bond. The present value of a bond’s cash flows, which are equal to the principal amount plus all remaining coupons, is the yield.
How do bond ratings affect investors?
(3) How do bond ratings affect investors? They understand the rating to mean that the higher the rating, such as BBB to AAA, the greater the bond’s investment grade status. The lower the risk rate, the higher the bond rating.
Is a BBB credit rating good?
Ratings firms investigate each bond issuer’s financial condition (including municipal bond issuers) and assign ratings to the bonds on the market. Each agency follows a similar structure to enable investors compare the credit rating of a bond to that of other bonds. “Investment-grade” bonds have a rating of BBB- (on the Standard & Poor’s and Fitch scales) or Baa3 (on the Moody’s scale) or higher. Bonds with lower ratings are referred to as “high-yield” or “junk” bonds since they are deemed “speculative.”
Why would someone put money into a low-rated bond?
- Because junk bonds have a lower credit rating than investment-grade bonds, they must provide higher interest rates to entice investors.
- Standard & Poor’s rates junk bonds as BB or lower, whereas Moody’s rates them as Ba or lower.
- The bond issuer’s rating shows the likelihood of default on the debt.
- If you want to invest in junk bonds but don’t want to pick them out yourself, a high-yield bond fund is a good option.
Why do businesses want a high bond rating over a lesser bond rating on their debt securities?
In general, the higher the bond rating, the better the bond issuer’s terms will be. Because investors want less compensation for the risk of default, high-rated bonds have lower interest rates. Bond issuers will have cheaper borrowing costs as a result of this.
In bond ratings, however, there is one very significant breakpoint. Bonds rated BBB- or Baa3 or higher are considered investment grade, which implies they can be owned by most institutional investors. Bonds rated BB+ or Ba1 or lower, on the other hand, are classified as high-yield bonds, sometimes known as trash bonds. Because these are considered to be more speculative, many institutional investors avoid them or have investment limits.
Bond ratings aren’t always accurate predictors of what will happen with a given bond, and ratings haven’t always worked as intended. Bond ratings, as a measure of relative strength, are an excellent place to start when researching a company’s debt.