Each bond is given a grade that indicates the credit quality of that bond; this grade is referred to be the rating of the bond. This rating comes from private independent rating agencies like Standard & Poor’s, Moody’s and Fitch; the agencies rate a bond based on the evaluation of the financial strength of the issuer (Crabtree & Maher, 2005). This means that the ability of the issuer to pay the principal amount of the bond as well as the interest in a timely manner is taken into consideration and then evaluation of the bond is done. The highest grade is ‘AAA’ while the lowest grade is ‘C’. below the grade B, the bonds are referred to as the junk bonds or the high yield bonds as there is a greater likelihood for these to be defaulted; for such bonds, the issuer pays a higher rate of interest so that the investor can be attracted. The price of a bond goes down if it is considered to be riskier; resultantly, the yield or the interest rate of that particular bond goes up (Friewald & Jankowitsch et al., 2012). So, the rating and the yield has an inverse relation for a bond. Lower the rating, higher the bond yield. According to the format used by Standard and Poor’s:
AAA, AA: high credit quality investment
AA, BBB: medium credit quality investment
BB, B, CCC, CC, C: low credit quality investment or junk bonds.
The par value of Land o’ Toys = $1000; market value = $1037.19; maturity in 10 years; annual rate of 6.5% with semi-annual payments. Current yield of bond= $65/ $1037.19= 6.3%. The yield to maturity is calculated with financial calculator equals 3%; according to the bond rating table, the bond has AAA rating. Here, N= 20, PV= 1037.19, PMT= 32.50, and FV= 1000. The bond is of high credit quality therefore the issuer does not need to provide a higher yield to attract the investors.
It Treasure Toys plans to purchase Land’o’Toys; Standard & Poor’s shift the rating of the bonds to BB considering the financial structure of the Treasure Toys after making the purchase. As the credit rating changes, the yield changes to 7.3%, redemption value = $1037.19, annual rate of 6.5%, calculated with the financial calculator, Bond Price = $961.47. This would be lower as the credit rating has also fallen to BB only; this means that the bond is riskier and the high yield is being offered to attract more investors for the bond so that money can be raised for the business.
APPLICATION
When the company is being purchased; usually the idea that the investor would get is that the company has run out of finances and so in order to raise capital, the ownership is being transferred and the company is being purchased. In such a situation, the investor would be bewildered and prefer to sell the bonds further and not to purchase the company’s bonds (Xiong & Yan, 2010). But according to the rating agencies, a higher yield that is 7.3% is being offered now; so, the investor’s ideas of high risk would be confirmed. But the yield is highly attractive as compared to what the bond was earning initially. This yield is more than double of that initial yield and so, it is an attractive offer for the investors to purchase the bonds.
The ratings and yields are indirectly linked to each other; as the risk increases, the price of the bond also decreases (Xiong & Yan, 2010). The investors would have to take into consideration their major goals and then handle the situation. The investors would consider whether the decline in rating is due to any disruptive event in the global economy or only due to the purchase of the company (Friewald & Jankowitsch et al., 2012). If it is merely due to the purchase, then the investors would feel comfortable in holding the bonds; but if there is some issue in the global economy, then the investors would prefer fleeing away and sell the bonds immediately (Han & Moore et al., 2012).
References
Crabtree, A. D. & Maher, J. J. (2005). Earnings predictability, bond ratings, and bond yields. Review Of Quantitative Finance And Accounting, 25 (3), pp. 233--253.
Friewald, N., Jankowitsch, R. & Subrahmanyam, M. G. (2012). Illiquidity or credit deterioration: a study of liquidity in the us corporate bond market during financial crises. Journal Of Financial Economics, 105 (1), pp. 18--36.
Han, S. H., Moore, W. T., Shin, Y. S. & Yi, S. (2012). Unsolicited versus solicited: credit ratings and bond yields. Journal Of Financial Services Research, pp. 1--27.
Xiong, W. & Yan, H. (2010). Heterogeneous expectations and bond markets. Review Of Financial Studies, 23 (4), pp. 1433--1466.
