Your Money: How rating agencies rate the risks that bonds carry

January 12, 2021 1:45 AM

Junk bonds are risky investments, but if the buyer is lucky and there is no default, then there could be sufficient money to be made via high coupons.

In the US market, investment banks have successfully marketed such bonds as high yield bonds.In the US market, investment banks have successfully marketed such bonds as high yield bonds.

By Sunil K. Parameswaran

One of the biggest risks for a bondholder is credit risk or default risk. This is the risk that the issuer may not pay the coupons on the scheduled coupon dates, and/or the risk that the face value may not be repaid on the scheduled maturity date. Unlike other inherent risks, such as interest rate risk or inflation risk, default risk varies from issuer to issuer. The rating agencies rate the securities.

To get a better rating, some issuers choose to have their bonds insured by an insurance company. The advantage is that such bonds are examined by two entities, in the sense that the process of due diligence is followed by both the rating agency as well as the insurance company. A good rating makes it easier and cheaper to borrow. In the case of an insured bond, the issuer will have to pay a premium to the insurance company. However, this may be passed on to the investors in the form of lower coupons, if the insured status facilitates a better rating. The insurance is typically irrevocable. That is, if the rating agency were to subsequently downgrade the issue, the insurance company cannot withdraw from its commitment.

Rating bonds
Like rating agencies, insurance companies also look at factors like the asset base of the issuer, the track record of the promoters, and the lines of credit available. If an emergency line of credit is available to the potential issuers, the odds of getting a better rating are brighter. In the case of bonds which are issued to fund projects with a projected revenue stream, the uncertainty associated with getting the cash flows is a key factor. The standard practice in the industry, in such cases, is to scale down the projected revenues and scale up the projected expenses and see whether the project is still financially viable.

Bond issues
Quality bond issues are rated as investment grade, that is they are recommended for investment. Others, which pose greater risk of default are called speculative grade, or non-investment grade, or junk bonds. Junk bonds may be the original issue of junk or fallen angels. Original issue junk bonds are issued by entities who are of poor credit quality at the time of issue. Fallen angels are bonds that were investment grade at one time but have been subsequently downgraded because of a deterioration in credit quality. Thus, such bonds will be characterised by low coupons and high yields to maturity.

Junk bonds are risky investments, but if the buyer is lucky and there is no default, then there could be sufficient money to be made via high coupons. In the US market, investment banks have successfully marketed such bonds as high yield bonds.

In countries like the US, investors can buy insurance policies for their individual portfolios. That is, if a person has 5000 IBM bonds, he can acquire a policy for his portfolio, which insures him against the spectre of default. The premium, in such cases, is directly payable by the bond holder.

The rating agencies have a reasonably good track record. Analysis of 80 years of data in the US shows that not a single AAA rated bond defaulted in the first one year after issue, and less than 1% of such bonds defaulted in the first 10 years after the issue.

The writer is CEO, Tarheel Consultancy Services

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