Credit ratings
Credit ratings provide a guide to the credit worthiness of a bond issuer
The bond market uses credit ratings to assess how good the credit worthiness of a bond issuer is. The credit rating forms part of an investor's assessment of what interest rate the issuer should pay.
Bond issuers obtain credit ratings from specialist rating agencies such as S&P, Moody's and Fitch.
Generally, bond issuers with better credit ratings pay less interest than those with the lower credit ratings. This is because companies (or governments) with better credit ratings are less likely to default (are considered less risky) than those with lower credit ratings.
Example
On a specific day,
Interest rate risk
This is the risk that you face when interest rates change.
Suppose today, you buy a new issue 3 year Gilt that pays 0.5% per year. Interest rates suddenly need to go up to control inflation. Tomorrow, the government issues a 3 year Gilt with a 3% interest rate.
The two bonds have the same credit default risk (the government) and the same maturity. You'd naturally prefer to own the bond with the higher coupon!
The bond paying 0.5% will suffer from interest rate risk - investors will sell it and buy the new bond that pays them more. What this means is that its price will fall so that the return (the yield) is the same as the newly issued bond that pays 3%!
When interest rates go up, the price of bonds generally fall. The reverse is true too. When interest rates fall, you'd expect bond prices to increase.
But Bond prices move.
Should you care?
That depends on whether you must sell. Many investors don't need to sell and so they don't worry that a bond has gone down in price because they take the view that the company will pay them back. It's like holding equity: prices go up and down. You have to make a call. If you need the cash, you may need to sell at a loss (or a gain!)
If you sell a bond below the price you paid for it, you'll make a capital loss. But whatever the price, the interest payable is always the same - whether you paid £80, £100, or £120. Let's look at yields now.
Bond yields?
Different to the interest!
The interest rate is also known as the coupon. Here, we have a 5% interest rate (a 5% coupon).
The yield is something different.
To keep things simple, if you buy Bondco's bond at £100 and hold it to maturity, your yield will be 5%. The yield is the same as the coupon because you paid £100 and received back £100.
Suppose the bond was offered to you for £80. Intuitively, you know you will make more money because you pay £80 and get back £100. Your "yield" has gone up. The yield on a bond therefore depends on the price you pay for it. If you pay more than £100, then your yield will be below 5%.
PRICE LESS THAN PAR? > > > YIELD MORE THAN COUPON
PRICE MORE THAN PAR? > > > YIELD LESS THAN COUPON