Introduction
Investing in a bond is about investing in an instrument with a known return and a known date of maturity. The return is defined by a metric called yield to maturity (YTM), which represents the total annualized return you can expect to earn if the bond is held until maturity, assuming all coupon payments are reinvested at the same rate. The YTM is a function of two variables: (a) the remaining tenure from the date of investment—longer maturity generally yields higher returns, and (b) credit quality—higher credit quality typically means lower returns. To gauge the credit quality of a bond, the relevant parameter is its credit rating.
Concept of Rating
A credit rating is an opinion given by a rating agency about the issuer’s ability to service the debt on time. This includes coupons (interest) payable at regular intervals and maturity proceeds payable on the defined date. Ratings are assigned to specific instruments (e.g., bond, debenture, or commercial paper). Technically, rating the organization, or issuer, of the instrument is possible, but it is rare. The opinion of the rating agency is communicated using alphabets. There are two rating scales: long-term (for maturities over one year) and short-term (for maturities of less than one year).
The long-term rating scale begins at AAA (the highest rating), followed by AA+ (next highest rating), then AA, followed by AA-, then A+ and so forth. The short-term rating scale starts at A1+ (highest rating), followed by A1, then A2+, then 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 (the India arm of Fitch), etc.
On the long-term rating scale, BBB- is considered the minimum investment grade, below which the rating is speculative or junk grade. It should be noted that the long-term rating scale is applicable at the time of issuance. For example, it is possible for an AA-rated bond with a five-year maturity, issued 4.5 years ago, to continue with an AA rating even though the residual or remaining maturity is only 0.5 years.
What Does It Mean for Investors?
When an investor is investing in a bond, they need to know the quality of the paper they are entering. A credit rating serves as a proxy or expert opinion on this credit quality. If it is a portfolio of bonds, then the rating of the underlying instruments denotes the quality. Institutional investors, such as banks or fund managers, have professional teams to assess this, but for individuals or non-professionals, credit rating serves as a yardstick.
When there is a change in credit rating (e.g., an upgrade or downgrade), it signifies the direction in which the issuer is moving. An upgrade means, in the opinion of the rating agency, the issuer is in a better position to service its obligations. A rating downgrade, however, is a note of caution.
Thus, the investor must gauge whether they are getting their money’s worth. As mentioned earlier, the return is denoted by the YTM, and credit quality by the credit rating. There is no exact correspondence between the credit rating of an instrument and its YTM, as this varies by issuer and fluctuates with market conditions and sentiment. However, it offers a valuable perspective. One can compare the YTM of a bond with that of similar instruments available at the time.
Limitations of Credit Rating
It is an opinion, not a guarantee. Rating agencies describe themselves as part of the “opinion industry.” In the case of issues with a highly rated instrument, they can defend their position by stating it was only their opinion.
Market perception: Pricing of a bond (i.e., its YTM) is influenced not only by the credit rating but also by perception. Institutional investors such as fund managers, banks, and large corporate treasuries, who have professional tracking teams, monitor issuer companies closely. For two companies with the same credit rating, YTM can vary significantly due to factors like the business group to which the issuer belongs, or recent developments that may not yet be reflected in the rating.
Conclusion
The corporate bond market in India is progressing and remains well-regulated, with ongoing improvements in liquidity in the secondary bond market. While there is no formal definition of high liquidity, liquidity levels are relatively low compared to developed bond markets or even large-cap equity stocks in India. This limits price discovery efficiency, necessitating professional fund managers who can balance returns (YTM) against risk (credit quality). Beyond professional fund management, credit rating provides investors with a perspective on the risk-reward ratio for their investments.