4. Bond Ratings : Necessary, not Optional

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Del curso dictado por Indian School of Business

Introduction to Financial Markets

523 calificaciones

Indian School of Business

Introduction to Financial Markets

523 calificaciones

Curso 1 de 5 en SpecializationFinancial Markets and Investment Strategy

Learn the general concepts of financial markets and economy. You will see the difference between primary and secondary markets and learn about markets for different products. You will also look at various economic Indicators and their influence on the markets. After completing this course, you will have a much stronger background of financial markets and ready to go to the next stage in the Specialization. This course is designed to help students with very little or no finance background to learn the basics of investments.

De la lección

Fixed Income Markets

In this module you will be exposed to the fixed income markets. Various types of fixed income securities available in the market are discussed. Learners are also taught the bond terminology.

1. Bonds : What are they?6:13

2. Interest Rates or Yields : Finding Direction9:11

3. Calling a Bond : Expect the unexpected7:57

4. Bond Ratings : Necessary, not Optional11:29

Conoce a los instructores

Vaidya Nathan
Lecturer
Finance

Learning outcomes.

After watching this video you will be able to understand the working of

the rating agencies.

You will also be able to assess the creditworthiness of a bond

issuer based on its ratings.

Now as you understand, bonds are basically IOUs,

which essentially means that corporations or

governments or agencies borrow money from you and

promise to repay that after a certain point of time.

So, one of the key things that you need to analyze before you invest in a particular

bond is to check out the probability of the money coming back to you.

Or in other words, what are the chances that the corporation or

the agency does not repay the money that it has borrowed from you.

And it's very difficult for individual bond investors to research

each corporation before they actually invest in the bond.

So this particular function of assessing the chance

of the bond issuer not repaying the money, or

in other words, the bond issuer defaulting is done

by firms called as rating agencies.

So, and they assign what are called as ratings.

So ratings basically measure the probability of a bond issuer

repaying the principal amount at maturity and

meeting all the scheduled interest payments.

So viewed another way, the rating agencies essentially rank

issues according to their perceived risk of default.

So they computed and published by independent organizations who

try to make an objective assessment of the risk of the principal not being returned.

The two best known rating agencies in the globally Standard & Poor's and Moody's.

The ratings are available on a subscription basis, and it's

available in a variety of publications that can usually be found in the Internet,

or the brokerage office through which you invest in the bonds can email them to you.

So together, these two rating agencies rate almost all the bonds

that are publicly issued, be it from corporations, be it from municipals,

be it from governments, so S&P and Moody's rate all

Treasury securities, bonds issued by agencies and so on.

So basically Moody's and

S&P together rate almost all the bonds that are publicly issued.

However, they do not

rate privately placed bonds unless they're asked to do that for a fee.

So now in recent years almost

half of all the bond issues that have happened have been privately placed,

which simply means that investors, which are usually institutions, have

purchased these bonds directly from the issuer without any public distribution.

Now the rating agencies use a very simple system of letters to assign ratings

which indicate their judgment of an issue's safety of principal and

interest payments stability.

So S&P, Standard & Poor's, ranks bonds from highest quality to lowest,

by using the first four letters of the alphabet in groups of three.

And they actually go as follows, it's triple A, which is AAA, double A,

single A, triple B, double B, single B, and so on, all the way through D.

Bonds which carry a rating of D are in default,

which means that there is considerable uncertainty.

So bonds which have a rating of D are in default.

Now investors commonly refer to the highest rating as AAA, okay.

Now a AAA security is as risk-free as it possibly can get, okay.

Now, Moody's also uses a similar rating as that of S&P, so you have AAA, AA, A.

Then you have instead of BBB by S&P,

in Moody's you have Baa, Ba, B, Ca, C, and so on.

Now a lot of times almost always

agencies use symbols to further refine a given rating.

Therefore S&P might add a plus or a minus sign to a rating.

For example, a single A+ rating is a shade higher or

a shade better than a single A rating.

And similarly, Moody's A1 is actually a shade better than a single A,

or for that matter, Moody's Baa1 is a shade better than Baa.

Similarly, an A- is a shade lower than a single A.

So basically, S&P and

Moody's use a plus or a minus sign to further refine the ratings.

So say, for instance, if a company has a single A plus rating,

that's a shade better than a single A rating.

Similarly, if a company has a BBB+ rating, that's again better than a BBB rating.

Similarly, if you have a company that is rated single

A- is a shade lower in terms of the safety of the principal and

interest compared to a bond which has a rating of single A.

Now in both systems, rating groups from AAA through B carry the same meaning.

So S&P's AAA and Moody's AAA have the same meaning.

So therefore,

Moody's opinion of a AA bond is basically identical to S&P's opinion on a AA bond.

Further, both systems clearly have boundary lines established

with the BBB and Baa rating, which in the first category is

indicating some speculative investment characteristics.

So bonds above BBB- are believed to be safe investments, and

therefore are called investment grade.

While bonds below BBB-, that is BB+, BB and so on,

should basically receive a very careful analysis of

the risk because they're inherently more speculative

than bonds which have a rating of BBB- and above.

So Baa ratings are more than, and

basically bond ratings are a lot more than just symbols, okay?

They are gauges of risk, and in the marketplace investors

almost always demand greater returns as risk increases.

Therefore, the lower an issuer's rating,

the greater the annual interest payments that is demanded.

Now since ratings can translate into millions of dollars of interest savings

for the corporation, rating agencies are understandably very careful and

thorough in pronouncing their opinions on default risk, which is what ratings are.

So each rating agency employs a staff of security analysts, who examine

the financial condition, the operations, and the management of a given issuer.

They also study specific documents such as the bond indenture,

which describes certain legal and technical details of the issue.

Perhaps the most important factor is the evaluation of the company's

future earning potential.

Now, in general, bond analysts test and

issue a strength under adverse market conditions with

an objective to determine the safety of the principal and interest payments.

So, therefore, after rating is given, it is typically reviewed periodically, and

is sometimes changed to reflect any improvement or

deterioration in an issuer's overall condition.

So, just to sum up, essentially,

as individual bond investors, we don't have the bandwidth or

the skill set to analyze the risk of default of each issuer,

be it a corporation or an agency or a municipality.

So therefore, the rating agencies do the job for us in trying to do an objective

assessment of the risk of the IOUs, which are what bond payments are all about.

So rating agencies make the job easier for investors to assess the risk.

And based on the risk assessment, typically if the bond is more risky,

i.e., has a lower rating, then the coupon on the bond is typically higher.

Similarly, the most risk free bonds, which have a rating of,

say, AAA tend to have the lowest coupon.

Be that for, and this is true globally not just in the US.

It's true for all countries in which bonds are issued and traded.

Please note that most of the ratings are country specific,

so a AAA rating in a country like, say, India or

China is not necessarily directly comparable to a AAA rating in the US.

So, for instance, if the US Treasury has rating of AAA, and

the Indian government securities also has a AAA,

that doesn't necessarily mean that these two AAA are comparable.

So you normally have ratings assigned in a particular country.

And it's better to basically compare ratings in a given country and

definitely in a given currency than comparing it

across different countries and different currencies.

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