Why to Invest in Higher Rated Bonds Like AAA, AA+ or A in India?
“Gentlemen prefer Bonds” - Andrew Mellon
Investing has become synonymous with stocks. However, stocks fail in the realm of
safety and stability. In such a case, bonds are the safest instrument for an
investor. While stocks are a great option, and carry a very high-risk reward ratio
not suitable for all investors. Investors should always think of a mix of
investments that will diversify their risk and make a proper portfolio.
From the above chart, we can easily see that even if bonds have
provided less return than equity, they have outperformed stocks in hard times and
given consistent returns.
Investment in
bonds is essential for investors with passive income needs. The issuers of
bonds are generally governments and large corporates.
Depending on the credit rating, a bond can be either an investment
grade or a non-investment grade.
So, should you invest in investment grade or non-investment grade bonds? Before
going to that section, let us understand what credit rating is and what it means for bonds.
Credit Ratings
A credit rating shows how likely the borrower is to return
investors' money, i.e., what is the borrower's creditworthiness.
A credit rating helps both the borrowers and investors. It helps
borrowers by raising money for their projects. It will also help the investors
to make sound financial decisions by analysing which bond to invest in.
The borrowers are given credit ratings by credit rating agencies
(CRA). These are institutions that evaluate the borrower's
creditworthiness.
Before giving a rating, a CRA takes into account many factors such
as the promoters background, issuer's repaying capacity, its business with past
performance and future growth in coming years, current and future liabilities,
economic development, global economic scenario, regulatory changes, etc.
In India, credit rating agencies include CRISIL Ltd, ICRA Ltd, CARE
Ltd and India Ratings and Research Pvt Ltd, among others.
The credit ratings rates papers from AAA to D based on how safe
the instruments are for investing.
All the credit rating agencies have their rating structures and
terminology.
Like in CRISIL, the credit rating is as
follows:
| SYMBOL |
SAFETY LAVEL |
| AAA |
HIGEST SAFETY |
| AA |
HIGH SAFTY |
| A |
ADEQUATE SAFTY |
| BBB |
MODERATE SAFTY |
| BB |
INADEQUATE SAFTY |
| B |
HIGH RISK |
| C |
SUBSTANTIAL RISK |
| D |
DEFAULT |
AAA, AA, A, and BBB are investment-grade bonds, and BB to D
are non-investment-grade bonds (also known as high-yield bonds or junk bonds).
Investment-grade bonds are those bonds that carry low
default risk. On the other hand, non-investment grade bonds have a high default
risk.
So, which investment grade bond should you look for?
Choosing Between Various Grades of Bonds
Investment-grade bonds (AAA, AA, A, and BBB) are preferable bonds as
they carry a low default risk compared to non-investment grade bonds.
‘AAA’ rated bonds for Investment are advisable for the following
reasons:
-
They have the highest degree of safety, so they will owner their obligation
in time towards interest and maturity amount.
-
AAA rated bonds have less correlation with equity, which helps an investor
to diversify the portfolio.
-
AAA rated bonds are considered as safe as risk-free
‘AA’ & ‘A’ rated bonds for Investment are also considered suitable
for the same reasons.
On the other hand, if you buy a non-investment-grade bond, there is
much higher chance of losing your principal amount.
Are bonds ratings trustworthy?
Credit rating agencies give credit ratings to any borrower by
analysing the different financial parameters after careful evaluation, and it is
evaluated on a regular interval of time. The rating of company might be differed
from one borrowing to other.
According to the report by CRISIL, 98.6%
of its AAA rating bonds remained AAA rated even after one year and 1.4%
were downgraded to AA, this happened between 2011 and 2021.
The rating of company can move downwards (like AAA to AA to A to
BBB to D) and upwards like (A to AA to AAA).
One important point to note is that no CRA can guarantee that an
AAA rated bond as on date will not default or downgrade in the future.
For example, issuers such as Infrastructure Leasing & Financial
Services (IL&FS) and Dewan Housing Finance Limited (DHFL) had AAA ratings at one
point. However, their ratings downgraded to D in less than one year when these
bonds defaulted.
Many large institutional investors have also started setting up
internal rating mechanisms to discover the credit quality of issuers.
Why not choose lower rated bonds for Investment?
Low rated bonds not always defaults or a bad investment
option. It all depends upon your risk tolerance, time, and goals.
If an investor is willing to take a high risk and wants to earn a
higher return, he could choose a low rated bond. However, before investing, they
should consider its pros and cons.
Not to borrow money to generate extra interest income on these
Bonds as it can be very risky as you might not be able to pay back the borrowed
money.
Further, lower credit rating bonds are illiquid, i.e., if an
investor sells the bond before maturity, he/she might have to give it at a steep
discount to fair value.
Conclusion
Investing in AAA rated
bonds or AA or low rated bonds is the choice of the investors. An
investor, after considering the pros and cons of both and their risk appetite
should make a call.
Investment-grade bonds are less risky but also offer low returns.
These bonds are suitable for those investors who are looking for a stable
income, the safety of their investment, and are risk-averse.
Investors should also know that credit ratings should not only be
the factor while investing in a bond, as credit rating is not a guarantee of
safety. It is simply an opinion of the credit rating agency.
Credit ratings should be used only as a broad filter to pick out
quality bonds before digging deeper into the bond's valuation metrics.
An investor should do thorough research before investing
in bonds.
One more vital point to note is that investors should not be attracted to high
yields in bonds before understanding their risk because high yield is
always associated with high risk.
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