Bond Ratings

Bond ratings assess the likelihood that the bond issuer will be able to meet its debt obligations, including interest payments and the return of principal at maturity. These ratings, assigned by agencies such as Moody’s, Standard & Poor’s (S&P), and Fitch Ratings, evaluate the creditworthiness of the bonds themselves, rather than just the issuers. These ratings range from high-grade (e.g., AAA, AA) indicating low risk, to speculative or “junk” (e.g., BB, B) indicating higher risk. The bond’s rating influences its yield, with higher-rated bonds typically offering lower yields due to their perceived lower risk, and lower-rated bonds offering higher yields to compensate for increased risk.

Rated bonds are typically categorized into two groups based on their credit rating:

• Investment-Grade Bonds: Bonds rated BBB- or higher are considered investment-grade, meaning they are relatively low-risk, with a strong likelihood that the issuer will meet its obligations.
• High-Yield (Junk) Bonds: Bonds rated lower than BBB- are considered high-yield or junk bonds, offering higher coupon rates to compensate for the higher risk of default.

For issuers, credit ratings are crucial as they directly affect the following:

• Investor Confidence: High bond ratings instill confidence in investors, signaling that the bond is a safe investment with a low risk of default. This can lead to greater demand and lower borrowing costs for the issuer.
• Marketability: Bonds with high ratings are more marketable and can be sold more easily in the secondary market. Investors are more likely to purchase bonds that have been rated highly by reputable agencies.
• Interest Rates: The rating of a bond directly affects the interest rate that the issuer must offer. Higher-rated bonds can be issued with lower interest rates, reducing the overall cost of borrowing for the issuer.

Unrated bonds are those that have not been evaluated by a credit rating agency. Issuers might choose not to obtain a rating for various reasons, such as to avoid the costs associated with the rating process or because they believe their bonds will still attract sufficient investor interest without a rating. However, unrated bonds generally carry higher risk, as investors do not have the benefit of an independent assessment of the issuer’s creditworthiness. As a result, these bonds often offer higher yields to compensate for the increased risk and are typically less liquid in the secondary market.

Secondary Market and Bond Listing

After the bonds’ initial issuance, they may be traded in the secondary market allowing investors to buy and sell bonds before they mature. The secondary market can be divided into two main segments: exchange-traded bonds and over-the-counter (OTC) bonds.

Exchange-Traded Bonds

Bonds listed on exchanges, such as the Hong Kong Stock Exchange (HKEX), are accessible to a wide range of investors, including retail and institutional investors. A bond’s listing on the stock exchange enhances its liquidity and transparency. Listed bonds are subject to the exchange’s rules and regulations, which often provide additional protections for investors.

Actual Exchange Listing: This involves the formal process of listing bonds on a recognized stock exchange. The issuer must meet the exchange’s listing requirements, which typically include providing detailed financial disclosures, adhering to regulatory standards, and paying listing fees. Once listed, the bonds can be traded on the exchange, offering investors a secure and regulated platform for transactions.

Technical Listing: This refers to the listing of bonds on an exchange without the intention of active trading. It is often done to meet regulatory requirements or to enhance the visibility and credibility of the bonds. Technical listings provide a formal recognition of the bonds on the exchange but may not involve significant trading activity (i.e. trading occurs OTC, see below).

Over-the-Counter (OTC) Market

The OTC market, by contrast, is less formal and typically involves large institutional investors. Bonds traded in the OTC market are not traded on a stock exchange, which means they are less transparent (in terms of publicly available information on prices and trading volumes) and may have lower liquidity compared to exchange-traded bonds. However, the OTC market allows for greater flexibility in terms of trading volumes and pricing, as transactions are often negotiated directly between buyers and sellers.

Conclusion

Credit ratings are essential tools for assessing the risk associated with bond investments, providing valuable insights into the issuer’s and/or the bonds’ creditworthiness. While unrated bonds offer higher yields, they come with increased risk due to the lack of an independent credit assessment. The secondary market for bonds, encompassing both listed/exchange-traded and OTC segments, provides liquidity and flexibility for investors. Understanding the factors that influence bond prices in the secondary market would allow issuers make informed decisions that optimize their capital structure and support their long-term financial goals.

Dominic Sze, Senior Of Counsel 

(E: dominicsze@hkytl.com T: +852 3468 7200)

This article is introductory in nature. Its content is current at the date of publication.  It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice based on your specific circumstances before taking any action relating to matters covered by this article. Some information may have been obtained from external sources, and we cannot guarantee the accuracy or currency of any such information.