A change in credit rating of a bond changes the yield the bond offers.
A rating downgrade of countries such as UK and China impact the global financial markets and the fund allocation. Such events influence the exchange rate and interest rates in the international markets. But how about the change in rating of a bond in your portfolio? Should you be worried about it?
“A change in credit rating of a bond changes the yield the bond offers,” says Deepak Panjwani, vice president – debt markets, GEPL Capital. To put it straight, higher the credit rating lower the interest rate the borrower has to pay. When you lend to an individual you will charge a higher interest rate as compared with a situation wherein you are lending it to State Bank of India in the form of a fixed deposit. The chance that the individual defaults on the payment of interest and repayment of capital is high when compared with a chance of a default by a nationalised bank.
The same applies in the bond market. A company with good balance sheet and fair business prospect will enjoy a high credit rating. Such a company will offer competitive rate of interest but need not go out of the way to attract investors in its bonds or deposits. However, a company with AA rating will surely offer more rate of interest than a company with AAA rating. AAA is the highest rating a company may get for its debt issues.
Changes in rating also matter
In the industry jargon, they call it rating downgrade, if the credit rating agency pulls down the credit rating of the company. This happens when the business performance deteriorates. However, if the credit rating agency is upbeat about the business performance and expects improvement, then there is a high chance that the rating will be elevated – upgraded, as they say it in business terms.“Rating downgrade of a bond leads to rise in yield payable on the bond and that leads to fall in price,” says Joydeep Sen, Mumbai based independent financial advisor. When the bond is downgraded from say AAA to AA+, the investors want an interest rate that a company with low rating will pay. That makes them adjust the price in secondary market. In that case the yield rises. This should be understood with an example. Say a bond with AAA rating offers a 6% interest and trades at its face value of Rs 100. It is trading at a yield of 6%. At the same time bonds with similar maturities but with AA rating are offering 7% yield in the market. At such a moment if the company with AAA rating is downgraded to AA then the price of that bond should adjust to 7% yield which will make it Rs 86.
When a rating is downgraded, the investor sees a marked to market loss. If the investor holds on to his bond investment, he recovers all his money, if the company pays back the capital as per the original terms on the maturity date.
“If the rating is upgraded, the investors adjust the bond price upward,” says Joydeep Sen. This means that the bond investors enjoy a marked to market profit or capital gain on his investment.
As per CRISIL Annual Default and Ratings Transition Study – 2016, during 1988-2016 around 93.8% of CRISIL AA ratings remained in that category at the end of one year. 1.5% were upgraded to CRISIL AAA and 5.2% were downgraded to CRISIL A category and below.
However, a word of caution. The bond prices do not move only on the basis of changes in ratings. “Changes in global interest rates, domestic liquidity, monetary policy actions, fiscal situation of a country among other factors also impact interest rates,” says Panjwani.If you are keen to invest in bonds with low ratings it is better to invest through credit opportunities funds. Such funds employ various strategies to invest in bonds with low ratings. Some invest in bonds maturing in near term and avoid taking interest rate risk. Some prefer to take a medium term view and want to play the possibility of rating upgrade. Such funds are exposed to interest rate risk. Understand the risk-reward matrix before committing your hard earned money.