Question

What do bond ratings measure? How do investors interpret bond ratings? What is the difference between an A-rated bond and a B-rated bond? Why are bond ratings important to investors? Why are ratings important to businesses that issue bonds?

Answer 1

Bond ratings measure the possibility and probability of default in the event of repayment by the bond issuer to the investor. A higher bond rating indicates a low probability of distress and a lower rating indicates a higher probability of distress or default in the event of repayment.

Bond ratings are rated in the following manner ie AAA>AA>A>BBB>BB>B etc where AAA is the highest rating while D is considered the lowest rating.

A rated is considered to be higher than B rated bonds as it is generally considered having low default probability. As B rated is having higher default probability, the risks of investing in B rated bonds are higher. This translates into higher risk and hence higher expected returns of yields on these bonds. Hence B rated bonds would typically have higher rates of return and yield to maturity.

Bond ratings help investors in decision making before investing in bonds. Investors based on their risk categorization can take an informed decision on which type of bond to invest and what its expected rate of return is based on its rating.

Ratings are also important to businesses as it helps it understand its cost of capital considering its risk of default. This is help itself during valuation purposes and in the event of raising new capital for expansion opportunities.