It is important to understand the use of credit rating in bond issuance in order to judge the credit quality of bonds. By the credit quality of bond issuance we mean the ability of the bond issuer to pay the principal as well as the interest at the scheduled date and time. The credit rating of bonds act as the financial indicator for the those who wish to invest .
The ratings of the bonds range from AAA to C. AAA represent the high quality bonds whereas C represents the low quality junk bonds . The different credit rating agencies use the same symbols to rate the bonds but differ in terms of the case ( lower or upper) used.
Standard and Poor’s rates bonds in the following fashion:
D: These are the bonds that have failed to repay back the principal or the interest.
BB,B,CCC,CC,C: These bonds are known as junk bonds having very poor credit quality. They do not fall in the investment grade
AA and BBB: These bonds are of medium credit quality and fall into the investment grade.
AAA and AA: These bonds are of very low credit risk and worth investing in.
Bond rating is basically done to evaluate the credit risk of the bonds. The rating of bonds does not suggest or reject any particular bond . But this rating is mandatory for making any investment decision.
Deciding Factors in Bond rating
Before rating any Municipal or corporate bond the following criteria are taken into consideration:
Structure of Debt
Managerial efficiency of the regulating bodies
Mathematical ratios are employed for making comparison between different bond issuances. Subjective parameters are also taken into account in ratings bonds.
Bond Ratings and Yield
Bond ratings have a strong bearing with its yield. If the bonds are rated very high, then issuers do not have to offer a high coupon rate in order to invite investors. In such a case the bond yield is low. Reverse is the case if bond ratings are low. The investors need higher compensations to deal with the high risk level. Automatically the bond yield is pushed up.