Key takeaways
- Check the credit rating of the issuer of your bond before you buy
- Higher risk bonds offer higher yields. These bonds are rated BB+ and below
- Lower risk bonds offer lower yields. They are called “investment grade” and are rated “BBB-” and above.
There are many issuers of bonds on the international capital market. Institutions known as Rating Agencies help investors assess the risks associated with buying and holding these bonds. They conduct an exhaustive and in depth analysis of the issuer in an attempt to provide an objective and impartial third-party opinion on the ability and willingness of an issuer to meet its financial obligations. The rating agencies publish “Credit ratings” based on their assessment of the issuer. Each credit rating corresponds to a different level of risk.
These credit ratings use an alphabetical-numerical scales to quantify the likelihood that you will receive interest and principal payments from the issuer. The highest rating a borrower can receive is ‘Aaa’ from Moody’s and ‘AAA’ from S&P – indicating that the issuer offers exceptional financial security or extremely strong capacity to meet its financial obligations. The lowest ratings are C or D – Moody’s and S&P, respectively – given to issuers that are in default. Any company rated BBB- (S&P) or Baa3 (Moody’s) and above – is referred to as “investment grade”. This means they are of relatively lower risk than bonds rated below BBB-/Baa3. Any bond that is rated below BBB-/Baa3 is called “high yield” or “junk”. These bonds are of a higher risk profile due to their lower credit quality. As a result they offer investors higher yields.
When determining a credit rating, the agency considers the country’s historical, current and projected profitability, cash flow position and balance sheet, in particular the existing debt it has on its books and the burden of servicing that debt. Past financial performance is also considered: A country that has at any time defaulted on its financial obligation is seen inevitably as seriously credit-impaired and will receive a low rating. The agency must also examine whether there’s a risk of changes in a government’s economic policies, or whether a new administration might repudiate their country’s debt.
The credit rating received by a country is a major factor in that country’s ability to raise funds and, to a great extent, establishes the rate of interest they must pay to obtain credit or issue bonds. A low credit rating will mean that, in order to persuade people to buy the bonds, the interest rate has to be very attractive – that is, worth the risk.
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Additionally, a simple downgrade, even in only outlook, may trigger a sell-off by investors, making a bad situation even worse. For example in December 2002, S&P revised the outlook assigned to Jamaica’s long term local and foreign currency sovereign credit ratings from “stable” to “negative”. This was an indication that the country rating may be lowered at the next review and resulted in foreign investors selling their holdings. Since there was tight liquidity in the Jamaican system, local institutions were unable to purchase the bonds – causing the prices to fall. Moody’s, on the other hand, maintained their stable outlook on Jamaica and this gave some support to the bonds when that news was released.
Judith Bloomfield is Operations Manager at Sterling Asset Management Limited.
Originally Published March 24, 2003