Introduction
Investing in a bond is about investing in an instrument with a known return and known date of maturity. The return is defined by a metric called yield to maturity (YTM), which is the compound annualized return you will get, provided you hold the bond till maturity. The YTM is a function of two variables: (a) remaining tenure from the date of investment - longer the maturity, higher the return and (b) credit quality - higher the credit quality, lower the return. To gauge the credit quality of a bond, the relevant parameter is credit rating.
Concept of Rating
Credit rating is an opinion given by the rating agency, about the ability of the issuer of the instrument, to service the debt on time. There are coupons (interest) payable at regular intervals and the maturity proceeds payable on the defined date. The rating is assigned to a particular instrument e.g. bond / debenture / commercial paper. Technically, rating of the organisation i.e. issuer of the instrument, is possible, but instances are rare. The opinion of the rating agency is communicated in terms of alphabets. There are two rating scales, long term (maturity more than one year) and short term (less than once year).
The rating scale for long term is AAA (highest rating), followed by AA+ (next highest rating), then AA, followed by AA-, then A+ and so on. The short term rating scale is A1+ (highest rating), followed by A1, then A2+, followed by A2 and so on. There are seven rating agencies in India: CRISIL (with a stake from S&P), ICRA (with a stake from Moody’s), CareEdge, India Ratings (India arm of Fitch), etc.
On the long term rating scale, BBB- is supposed to be the minimum investment grade, below which it is speculative or junk grade. To be noted, the long-term rating scale is applicable at the time of issuance. As an example, it is possible for a AA rated bond with 5-year maturity, issued 4.5 years ago, to continue with AA rating even though residual or remaining maturity is 0.5 years.
What does it mean for investors?
When an investor is investing in a bond, s/he has to know what is the quality of the paper s/he is getting into. It is a proxy or expert opinion on the credit quality. If it is a portfolio of bonds, then the rating of the underlying instruments denotes the quality. Institutional investors like banks or fund managers have professional teams to assess it, but for individuals or non-professionals, credit rating is the yardstick.
When there is a change in credit rating e.g. upgrade or downgrade, it signifies the direction in which the issuer is moving. An upgrade means, in the opinion of the rating agency, they are in a better position to service their obligations. Rating downgrade is a note of caution.
The investor has to gauge whether s/he is getting money’s worth. As mentioned earlier, return is denoted by the YTM and credit quality by the credit rating. There is no exact correspondence on credit rating of an instrument and YTM. It varies from issuer to issuer; market conditions and sentiments change frequently. However, it at least gives a perspective. One can compare the YTM of a bond with the relevant cohort available at that point of time.
Limitation of credit rating
It is an opinion: it is not a guarantee. Rating agencies call themselves “opinion industry”; in case of any issue with a highly rated instrument, they have the alibi that it was only their opinion.
Market perception: pricing of a bond i.e. the YTM is a function of not only the credit rating but also the perception. Institutional investors like fund managers, banks, large corporate treasuries etc., who have professional teams, track the issuer companies. For two companies with the same credit rating, YTM can be palpably different. It could be about the business group the issuer belongs to, any development in the company yet to lead to change in credit rating, etc.
Conclusion
The corporate bond market in India is developing and remains well-regulated, with ongoing improvements in liquidity in the secondary bond market. While there is no definition of high liquidity; compared to developed bond markets or say large cap equity stocks in India, liquidity is relatively low. Hence, price discovery is not very efficient. This necessitates going through a professional fund manager, who can balance between returns (YTM) and risk (credit quality).
Apart from professional fund management, credit rating gives a perspective to the investor on the risk-reward ratio for his/her money.
Disclaimer - Investments in debt securities / municipal debt securities / securitized debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully