How do upgrades and downgrades affect bonds?

Every instrument in the financial market is subject to fluctuations, just at different degrees. Due to changes in the economy, the issuer’s status and various other parameters, the value of financial instruments changes consistently. Bonds are no exception to this. 

Bonds are exposed to lower risks than stocks. However, they are volatile, too. Hence, considering the factors affecting the prices of bonds before investing in them is crucial. Today’s article revolves around one such parameter that plays a significant role in a bond’s price fluctuation.

What are bonds?

Bonds are a form of debt instruments that provide a fixed rate of interest to investors throughout their tenure. The government or corporations are issuers of such bonds that issue these instruments to raise debt capital from the public. Investors act as lenders and lend a certain amount of money to the issuer, for which investors receive periodic interest.

Some vital components of bonds are:

• Face value: Amount that issuer pays during maturity
• Market value: Price of the bond to buy it from the secondary market
• Tenure: Suggests the bond’s maturity
• Interest or coupon rate: Suggests the rate of interest per annum

What is a bond rating?

Despite bonds being safer than stocks, they carry various kinds of risks such as credit risks, interest rate risks, etc. The degree of risk exposure has a significant bearing on the bond’s quality. 

Investors usually assess these risks based on how the bond has performed over the years concerning price fluctuations, interest payments, etc., before making an investment decision. One such tool that helps in easy assessment is bond rating.

Credit agencies are authorised institutions that maintain credit information about various entities, including individuals, businesses and financial instruments. These agencies assess bonds and rate them according to their performances. The rating acts as a basis for profitable investment decisions.

AAA being the best rating and D being the lowest, credit rating agencies like CRISIL and Moody’s analyse the performance of bonds and rate them accordingly. The rating changes from time to time depending on how bonds react to various market events.

Bonds with the highest rating of AAA are considered safer than the other bonds and stable in providing returns. Conversely, bonds with low ratings, like D, are called junk bonds since they are highly risky and unstable.

Bond upgrades

When the rating of a bond improves, the bond is said to have upgraded. For example, a bond with a rating of BBB moving to a rating of AAA is an upgrade. This happens when the bond is expected to react positively to market events.

Causes

Various factors affecting the bond issuer positively cause the upgrade of a bond. 

• When the bond issuer’s financials go green, the ratings upgrade as the issuer’s potential to meet financial commitments increases.
• When the issuer expands the business in terms of operations and profits, the credit rating increases.
• Policies in the country that affect the issuer positively, for example, increasing focus on reducing pollution in the country, affect electric vehicle manufacturers positively, raising the credit rating of their bonds.

Bond downgrades

When a bond’s rating diminishes, it goes through a downgrade. For example, when a CCC-rated bond goes down to a CC-rated bond, the credit risk is said to have increased. It is considered that the issuer may default on payments, making the bond an unsafe option. Downgrades happen when market events are expected to affect the bond negatively.

Causes

• Instances of defaults in repaying the principle or meeting interest commitments on time affect the bond rating negatively.
• A dip in revenue, profits or other material aspects of the issuer’s balance sheet causes a downgrade in rating.
• Negative economic events like recession and depression that affect the investment capabilities of investors impact the rating of bonds in general.

Impact of upgrades and downgrades on bonds

The bond’s price moves in the same direction as its rating. While the face value remains unchanged, the market value varies in the direction of the rating.

An upgrade in rating leads to an increase in the bond’s market price. A downgrade in rating leads to a decrease in the bond’s market price. The logic is simple, an upgrade suggests a stable bond increasing its price and demand. A downgrade suggests a risky bond decreasing the price and demand. 

Bond yield, on the other hand, moves against the rating. As the rating upgrades, the market price increases. The interest rate, however, remains the same, making the overall yield less. Conversely, a downgrade decreases the market price. Since the interest rate remains constant, the final yield increases.

Bottomline

Analysing the historical performance of financial instruments and forecasting their future movements is a crucial step while making investments. Since it requires technical expertise, novice investors might find the analysis complex. That is where bond rating plays a major role in analysing bonds. 

So, make sure to check the rating before choosing your bond! Happy investing!

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