Importance of Bond Ratings

by Maestri

Bond ratings are important both to firms and to investors. First, because a bond’s rating is an indicator of its default risk, the rating has a direct, measurable influence on the bond’s interest rate and the firm’s cost of debt. Second, most bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to investment-grade securities. Thus, if a firm’s bonds fall below BBB, it will have a difficult time selling new bonds because many potential purchasers will not be allowed to buy them. In addition, the covenants may stipulate that the interest rate is automatically increased if the rating falls below a specified level.

As a result of their higher risk and more restricted market, lower-grade bonds have higher required rates of return, rd, than high-grade bonds. Figure 4-4 illustrates this point. In each of the years shown on the graph, U.S. government bonds have had the lowest yields, AAAs have been next, and BBB bonds have had the highest yields. The figure also shows that the gaps between yields on the three types of bonds vary over time, indicating that the cost differentials, or risk premiums, fluctuate from year to year. This point is highlighted in Figure 4-5, which gives the yields on the three types of bonds and the risk premiums for AAA and BBB bonds in June 1963 and August 2001.16 Note first that the risk-free rate, or vertical axis intercept, rose 1.5 percentage points from 1963 to 2001, primarily reflecting the increase in realized and anticipated inflation. Second, the slope of the line has increased since 1963, indicating an increase in investors’ risk aversion. Thus, the penalty for having a low credit rating varies over time. Occasionally, as in 1963, the penalty is quite small, but at other times it is large. These slope differences reflect investors’ aversion to risk.

Taken From : Five-Minute MBA – Corporate Finance