A bond is a financial transaction generally between two parties, the borrower (bond issuer) and the investor (bondholder). In other words, a fixed income instrument (another word commonly used to describe bonds) is merely a loan whereby investors lend money to borrowers, more often than not for a finite term and at a pre-determined rate (generally fixed but also floating) of interest.
When a bond is issued, one of the crucial criteria investors generally look out for when contemplating investing in a bond is the rate of interest. This interest/coupon ultimately determines the periodical coupon payments throughout the duration of the financial instrument, which is dictated by the investor’s perception of risk assigned to that type of investment in addition to the general market conditions at the time of issuance. Credit ratings are a commonly used measurement of bond risk, both at issuance as well as along the lifetime of the bond. This is the market’s standardised measure of risk determining the financial strength of a bond issuer, amongst many other crucial factors.
The credit score of a bond issuer and bond issue, transposed into a credit rating, is the financial results of a highly complex and detailed and through analysis of the forward-looking credit worthiness of a bond issuer, which is based on the probability or likelihood of a bond issuer defaulting on its debt and financial obligations. A credit rating takes into account both company specific information also keeps in mind and assigns a weighting to the analysts’ outlook of the industry in which the bond issuer operates, the country of operation as well as other external factors.
Standard & Poor’s, Moody’s and Fitch are 3 of the most and highly reputable rating agencies which carry out such in-depth analysis of issuer strength. These agencies use standard scoring measures, in the form of letter designations, starting from A to D (with varying degrees of risk in between) – with A representing a strong credit profile of the bond issuer and a lower probability of default when compared to lower rated bonds, i.e. from B downwards.
Therefore, credit ratings are rankings/scores whereby a rating agency assigns to each issuer reflecting their expectations regarding the likelihood of solvency issues (of the underlying bond issuer) which could ultimately lead to bankruptcy. Generally, credit rating agencies, upon assigning a credit rating to a bond or a bond issuer, will disclose the reasoning behind their analysis and final score and will also divulge, most importantly their forward looking statements, assumptions and scenario analysis which could result in the possible upgrade or downgrade of the previously assigned credit rating in the months to follow.
Given the fact that credit ratings are based on probabilities, credit rating agencies usually opt to reflect this and not indicate a hard and fast rule that their assigned ratings are indeed such when classifying bonds, using vague terms such as “the bond issuer’s capacity to meet its financial commitment on the obligation is extremely strong” which could be subject to interpretation.
Nevertheless, all 3 credit rating agencies use different variations of alphabetical combinations to classify the financial strength of a bond issuer. Examples as follows:
AAA (S&P); Aaa (Moody’s); and AAA (Fitch) – Premium quality bonds
A+ (S&P); A1(Moody’s); and A+ (Fitch) – High Grade Bonds
BBB (S&P); Baa2(Moody’s); and BBB (Fitch) – Lower Medium Grade Bonds
BB (S&P); Ba2(Moody’s); and BB (Fitch) – Non Investment Grade Bonds
B- (S&P); B3(Moody’s); and B- (Fitch) – Highly Speculative Bonds
Having highlighted the above, we must opine the fact that bond investors ought to appreciate that, throughout the lifetime of bond, yields fluctuate and hence bond prices will reflect the change in market yields, both based on market risks as well as issuer specific risks. On the latter, investors will require a risk premium assigned to a bond investment of that type; the stronger the financial position of the issuer, the lower the risk premium and the weaker the financial position of the issuer, the greater the risk premium.
Hence it comes as no surprise that, following a upgrade or downgrade by credit rating agencies, or as well as any form of company announcement which indicates that forward looking financial healthy, liquidity and solvency of the issuer, the bond prices (or yields) will adjust to reflect the prospective risks of the bond investor, which primarily is based upon the likelihood or probability that a bond issuer defaults on its financial obligations.
Despite being a powerful and highly utilised tool in the industry within which we operate in assessing a company’s credit risk and financial strength/sanity, one of the key short-comings of credit ratings is that they are based on ordinal measures, which means that credit ratings give and highlight a chronological perspective, but they do not capture and specify the inherent and relative risks between one bond issuer and another.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.