Understanding Bond Investment Risks and Credit Ratings
When investors purchase bonds from borrowers, they risk that the borrower will become unable to repay the bond par value at maturity or pay the interest due on future interest payment dates.
Credit rating agencies evaluate a borrower's economic base, historical fiscal results, social-economic statistics such as population or schooling, and they conduct an analysis to estimate the credit risk associated with a specific issuance or lien. The agencies produce a credit rating investors can use to help decide if a bond’s return is worth the risk of non-repayment by the borrower, as well as a report detailing this analysis.
A high credit rating can place the borrower in the “investment-grade” category to show investors the relatively low risk of investing in that bond. This can help lower the yield of the bonds being issued, as they are considered a safer investment for investors.
There are four main rating agencies in the US: Moody's Investors Service, S&P Global Ratings (S&P), Fitch Group, and Kroll Bond Rating Agency. Each evaluates a different mix of factors to produce an issuer’s credit rating as a letter grade.
Depending on the backing of the bond, credit agencies look at different parameters.
For bonds backed by taxing power, credit agencies typically look at the following:
- Economic diversity in the tax base
- Growth in employment opportunities
- Economic base trends in population
- Employment and personal income
For bonds backed by the revenues of the financed project, credit agencies typically look at the following:
- Need of the project in the area
- Management of the project
- Any competing project within the area
- Bond indenture features, such as the presence of a debt service reserve fund
- Rate setting ability, such as the ability to increase tolls with little loss of road usage and few bureaucratic barriers
Not all bonds get rated by all the agencies. Many only seek two or three ratings. If the repayment of the bond is very risky, the borrower might elect to not have any credit agencies rate their bonds, which is a sign to potential investors of a major risk of repayment.
Example:
Imagine a borrower that governs an area with a rapidly growing economy, a large population of high earners, and a significant, diverse tax base. These all indicate a high likelihood of paying back a general obligation bond, so the bond would likely get a high credit rating.
What’s important here?
All else equal, the higher a borrower’s credit rating, the lower the yield has to be set on a bond to attract investors. Since the bond is seen as less risky, investors are satisfied with a lower yield bond than if the bond was issued by a borrower with a lower rating.
It’s worth noting that agencies judge a bond issuer’s economic base differently for general obligation issuances and revenue obligation issuances, as the security backing these different credit types will be subject to different risks and considerations.
