Like all financial instruments, a bond (also known as a fixed [or floating] income instrument) is a financial transaction between two parties, the borrower and the investor.
In simple terms, a bond is a loan whereby investors lend money to borrowers, generally for a fixed period and at a pre-determined rate of interest. As one of the most commonly used financial instruments in global capital markets, bonds are generally perceived to be of lesser risk than equities, for example, but one must not undermine the inherent risks of a bond, both at inception as well as throughout the lifetime of the bond itself.
Upon issuance, one of the crucial criteria investors look out for when contemplating investing in a bond is the rate of interest which will determine the periodical coupon payments throughout the duration of the financial instrument, which rate of interest is primarily determined 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.
A commonly used measurement of bond risk, both at issuance as well as along the lifetime of the bond, is the Credit Rating of the Issuer, which is a standard measure of risk determining the financial strength of a bond issuer, amongst many other crucial factors.
In other words, a credit rating is the result of a highly complex and detailed examination 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 will be based on both company specific information but will also depend on the outlook of the industry in which the bond issuer operates, the country of operation as well as other external factors.
Credit ratings analysis is generally carried out by the big three credit rating agencies, namely Standard & Poor’s, Moody’s and Fitch. These agencies use what are known as 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 - from B downwards.
As stated above, credit ratings are rankings in which a rating agency places on each issuer reflecting the likelihood of solvency issues 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 include, most importantly forward looking statements and scenario analysis which could result in the possible upgrade or downgrade of the previously assigned credit rating
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 terms such as “the bon issuer’s capacity to meet its financial commitment on the obligation is extremely strong," or "less vulnerable to non-payment than other speculative issues.
All three credit rating agencies used 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
It is imperative for a bond investor to appreciate that, throughout the lifetime of bond, bond prices will fluctuate, 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 in assessing a company’s credit risk, 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 & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.