(87)---DEFAULT RISK AND CREDIT RATING

Default Risk and Credit Rating

Default risk is the risk that a company will default on its promised obligations to bond holders. Bondholders can avoid the default risk by investing their funds in the government bonds instead of the corporate bonds.
Investors invest in corporate bonds if they are compensated for assuming the default risk.
Hence companies in order to induce investors to invest in their bonds, offer a higher return than the return on the government bonds. This difference called default premium.
How do Investors asses the default risk of bonds?
In most countries there are credit rating companies that rate bonds according to their safety (In USA Moody’s and Standards and Poor’s and others provide bond ratings).

1. High Investment Grades
   AAA (Highest Safety)
   Debentures rated “AAA” are judged to offer highest safety of timely payment of interest and principal.AA (High safety)Debentures rated “AA” are judged to offer high safety of timely payment of interest and principal. They differ in safety from “AAA” issues only marginally.
2. Investment GradesA (Adequate safety)Debentures rated “A” are judged to offer adequate safety of timely payment of interest and principal. However changes in circumstances can adversely affect such issues more than those in the higher rated categories.
   BBB (Moderate safety)
   Debentures rated “BBB” are judged to offer sufficient safety of timely payment of interest and principal for the present however changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories.
3. Speculative Grades
   BB (Inadequate Safety)
   Debentures rated “BB” are judged to carry inadequate safety of timely payment of interest and principal.B (High Risk)Debentures rated “B” are judged to have greater susceptibility to default while currently interest and principal payments are met adverse business or economic conditions would lead to lack of liability or willingness to pay interest or principal.C (Substantial Risk)Debentures rated “C” are judged to have factors present that make them vulnerable to default.
   D (In Default)
   Debentures rated “D” are judged to have grater susceptibility to default.