It is advisable to go for the highest-rated bonds
With the news of Urjit Patel being announced the next governor of Reserve Bank of India, there has been a movement in the government bond yields. The 10-year bond yield now stands around the 7.15%-mark, levels not seen since September 2009. Expectations are that bond yields could fall further.
Bonds are fixed income securities. With them, investors lend their money to government or corporate entities in exchange for interest income to be paid out with the capital after a pre-determined period.
Types of bonds
Bonds can be broadly categorised into two major types. The first is government securities issued by governments and their institutions to fund their financial requirements. The second is corporate bonds issued by companies.
Government bonds are deemed to be risk-free because governments rarely default on payments.
There are risks associated with corporate bonds. If companies don’t earn profits, they may not be able to pay interest to bond holders.
At the same time, “high-grade” corporate bonds are as good as government securities because there is a low probability of default. This grade, also known as rating, is what differentiates corporate bonds.
There’s been a good year for corporate bonds in India. In May, data from Sebi revealed that over 89.5% of corporate India’s debt securities in 2015-16 were rated as “safe for investment”, up from 61% the previous year.
It means that these bonds were given a rating between “highest safety to moderate safety”. What do these ratings mean?
Rating of bonds
It is mandatory for every bond issue to go through a rating process conducted by one of the rating agencies such as ICRA, CRISIL, and CARE. These agencies assess the financials, past record, future prospects, and other aspects of the bond-issuing entity before assigning a rating to their bond.
Essentially, the rating is a result of the evaluation on the following criteria:
Financial risk: Financial risk evaluates if a company has enough funds to pay their bond investors. Can the project for which bonds are issued generate enough returns?
Will the cash flows be managed well? This risk evaluates if the project revenue and income can be realised and with what certainty.
Business risk: This evaluates the risk the business of the company may face in future. In other words, if the company faces business risk, can it still pay the bond investors their due? This risk considers sectors, government regulations, overall economic sentiments, and economic growth.
Competence of management: This factor evaluates if the management has the competence and integrity to pull off the project and conduct business profitably.
Fundamentals of the company:
Finally, the fundamentals of the company in terms of past records, profitability, growth in terms of income etc. are evaluated.
The ratings provided by rating agencies are almost similar, as is the process followed. For illustrative purposes, we take the example of CRISIL ratings for long-term debt instruments.
The best ratings assigned to bonds are AAA, AA and A – AAA being the highest rating that means that the safety of capital and interest is the highest for bonds with these ratings. AAA-rated bonds offer the lowest probability of default.
AA (high safety) and A (adequate safety) are followed by lower ratings of BBB (moderate safety), BB (moderate risk), B (high risk), C (very high risk), and D.
The lowest ratings are C, and D which projects a high chance of default on payments.
Rating agencies make it easy for investors to pick a bond. Naturally, a highly-rated bond will yield lower interest while a low-rated bond will have to offer a higher interest in order to attract investors and offset the risks.
The purpose of investing in bond or bond funds is to get fixed income. Hence investors should look at safety of principal with average returns.
Therefore it is advisable to go for the highest-rated bonds. Identify your investment goals and choose the right type of bonds based on what you want to achieve in terms of returns and how much risk you are willing to take for the same.
The writer is CEO of BankBazaar.com