What are AAA Rated Bonds?
AAA rating is awarded to those bonds that have promising creditworthiness. Bonds that have addressed their financial commitments and have the lowest credit risk fall in the category of AAA ratings. Such ratings can also be awarded to corporations.
Rating agencies use AAA’s impression to find bonds with high credit quality. It is because the level of credit rating of an issuer directly impacts the borrowing rate in the open market. The bigger the credit rating is, the lower the borrowing expenses are and vice-versa.
Note: The term default states that a bond issuer failed to provide the principal amount interest payment because of a particular investor. AAA bonds have the lowest risk of default; hence, they offer lesser payback than other bonds on the maturity date.
Understanding AAA Rated Bonds
Since the risk of default in AAA bonds is significantly low, such investments propose investors with the lowest yields in the market. Compared to bonds with resembling maturity dates, AAA bonds include lower risk, hence lesser return.
There are top-three leading credit rating agencies in the market, namely Fitch, Moody, and Standard & Poor’s. These agencies offer credit ratings for an extensive range of debt securities like corporate bonds, debt issues, etc.
Even though all three agencies have an exclusive scale for rating debt issues, AAA is still used to symbolise the highest grade. AAA rating is also endowed to companies and government debt corporate bonds, where the corporation is robust enough to address its financial commitments.
Here are the key points to analyse and determine the debt of a company:
- Tax burden
- Profit margins
- Pension obligations
- Debt load
- Revenue growth
- Future industry outlook
- Earnings growth
- Regulatory climate
Note: The concept of default is related to bond issuers who fail to meet the mandatory obligations. Such obligations may include the inability to make semi-annual interest payments or repay the principal amount.
Types of AAA Bonds
AAA rating is classified based on the type of bond available. Here is a brief overview of the type of AAA bonds:
1. Municipal Bonds
Municipal bonds are generated as general obligation bonds or revenue bonds. Each of these bonds is dependent on different income sources.
Obligation bonds depend on the issuer’s ability to generate capital via imposing a tax. While on the other hand, revenue bonds are compensated using fees and different income-generating revenues like sporting venues, city pools, etc.
Here is a brief overview of the two:
- Revenue Bonds
They lack government backing and tax provisions. However, they are fueled by funds from a particular source or projects like lease fees or highway tolls.
A few of the revenue bonds are non-recourse. It signifies that bondholders cannot claim on the fundamental revenue source in case the revenue stream runs out.
- General Obligation Bonds
These bonds are generated by cities, states, or countries. They are not secured by assets and are sustained by the issuer’s credit.
Note: It is significant to add that municipal borrowers often issue bonds supporting private entities like hospitals or non-profit colleges. Such borrowers usually approve to repay the issuer who reimburses the principal and interest on the bonds.
2. Secured vs Unsecured Bonds
When a loan (personal loans, bonds, or mortgages) is acquired, it is obtained on credit or faith. When a bond is secured, it is backed by something valuable. If a bond is based on faith, it is sustained by the promise of the borrower to reimburse the principal amount.
A bond is secured if it is collateralized. It means something collateral is supporting the loan, for example, mortgages. When the issuer fails to reimburse the principal or interest payment, the collaterals are sold or liquidated, and the amount is remitted to the bondholders.
When a bond is deployed on credit or full faith, it is called unsecured. It is backed by the promise of the issuer to pay the borrowed funds. Bondholders can still sue them if the issuer fails to provide the payments.
However, bondholders are more likely to lose their investment if the issuer is bankrupt or has no funds.
Hence, secured bonds are a better investment option than unsecured ones. As a result, they are issued with minimal interest rates and offer lower yields, unlike unsecured bonds, where the risk for investors is higher.
Benefits of a AAA Rating
Here is the list of the benefits of an AAA rating:
- A higher credit rating decreases the borrowing cost of the borrower or issuer
- Companies with higher ratings can get vast sums of money rather than fixed-income debt instruments with lower credit ratings.
- The low cost of borrowing adds a competitive advantage to firms by enabling them to receive credit easily to boost business development.
- Bond with AAA ratings are less likely to default on principal repayments or interest payments
- A company can easily buy out its competitor since it can cheaply borrow money for the transaction expenses concerning acquisition and merger.
Conclusion
Credit ratings are allocated to bonds and debt issues by debt rating agencies. An improved credit rating reduces borrowing costs significantly. Consequently, it impacts the borrowing cost for the issuer.
Not to mention, AAA ratings are the highest rankings generated by credit agencies and may give rise to lower borrowing yields or expenses. Hence, investors looking for a lucrative return should consider the credit rating cycle with lower ratings and higher yields.