You have just won the Strayer Lottery jackpot of $11,000,000. You will be paid in 26 equal annual installments beginning immediately. If you had the money now, you could invest it in an account with a quoted annual interest rate of 9% with monthly compounding of interest. What is the present value of the payments you will receive?
Amount $11,000,000
Annual installments 26
Interest rate 9%
Present value to be estimated
Compound interest (Monthly) 9%
Installments 312
Interest rate 0.75%
Present value of payment $1,068,896.32
In your own words and using various bond websites, please locate one of each of the following bond ratings: AAA, BBB, CCC, and D. Please describe the differences between the bond ratings. Identify the strengths and weaknesses of each rating
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Bond rating refers to the grade assigned to a bond depending on its credit quality (Investopedia, 2018a). The rating helps investors to make the right decision when they want to invest in securities like bonds. In particular, it enables them to establish a firm’s credit risk. In the United States, major rating agencies use letters A, B, C, and D for the rating. According to Investopedia (2018a), letter “A” shows the best rating while letter “D” denotes the lowest rating. The various credit agencies use same alphabets to show a grade. However, they show variations in the sense that some use upper-case letters only (such as AAA) while others use a combination of both upper and lower case letters (such as Aaa) to rate bonds. Regardless, of the differences, the letters involved shows the bond rating.
An “AAA” bond rating is the highest rating that credit rating agencies assign to a bond. Investopedia (2018b) shows that this type of bond is associated with an excellent degree of creditworthiness since the issuer can still satisfy its financial commitments. Fitch and Standard & Poor (S&P) rating agencies use AAA to identify this type of bond while Moody’s uses Aaa to indicate loans with the highest credit quality (Wilkinson, 2013). The demerit of this type of bond is that they offer investors the least yields compared to other bonds with similar maturity periods. That is because these types of bonds are associated with low risk. Nevertheless, AAA-rated bonds are meritorious to businesses since they tend to lower the costs of for the lender. As such, it allows companies to borrow large amounts of money. According to Investopedia (2018b), a reduced price of borrowing is a competitive edge since firms can capitalize on such opportunities to access credit easily.
BBB bond rating is the lowest investment grade since the ratings below this bonding grade are deemed high yield bonds or “junk bonds.” Thus, a rating of BBB implies that the bond is still in the investment grade bond. However, this type of bond has a higher risk compared to the AAA rated bond. The higher risk contributes to higher interest rates. It is therefore upon an investor to assess whether it is worth investing in this type of bond to get a higher interest rate (Nelson, 2017). Even though the BBB rated bond is assigned an investment grade rating, it is worth noting that it is the lowest investment rating. In that regard, a single downward trend would render the bond a junk, and its price would be affected adversely. Most experts discourage investors from investing in this type of bond since downgrade is associated with a lot of volatility. In such instances, firms may be forced to sell their bonds to adhere to their rules (Nelson, 2017).
As you move from “B” to “C” bond rating, the level of risk involved increases. Bonds rated CCC are linked with higher risks. Traditionally, one would expect returns to rise when the as the risk increases. Nevertheless, indiscriminate exposure to this type of bond might fail to yield the expected results in some instances (Alliancebernstein.com, 2018). Under the CCC bond type, the risk of defaulting increases since the ability of the issuer to settle payment relies on the financial performance of the business and the prevailing economic conditions. For instance, when the conditions are unfavorable, the issuer is more likely to default the bond as opposed to when the economic conditions are favorable. The CCC-rated bonds, nevertheless, provides managers with a fertile ground for reaping returns. According to Alliancebernstein.com (2018), this type of bond offers active managers a chance to reap rich rewards. For example, when there is high anxiety in the market, such managers can rely on strong research to get appealing buying opportunities.
The DDD rated bonds are also regarded as junk bonds (Investopedia, 2018a). These refer to bonds that have breached the terms of bond agreement or payments have defaulted. Moreover, the bond could be in instances where an issuer faces bankruptcy petition. It is without a doubt that this is the riskiest bonds investors can invest in since the possibility of defaulting is almost certain (Investopedia, 2018a). The merit of this bond is that it provides the issuer with dynamic options to capitalize on the market when the environment is unpredictable. High returns could be achievable if the investor relies on extensive market research. DDD rated bonds, however, are not for every investor. A significant number of investors expect massive returns, yet they are scared of the volatility associated with this type of bond. Such people would always embrace ideas or take actions that would reduce their exposure to the risks related to lowly rated bonds such as the DDD bonds.
References
Alliancebernstein.com. (2018). Is CCC credit worth the risk? Retrieved on 12 October 2018 from https://blog.alliancebernstein.com/post/en/2012/08/is-ccc-credit-worth-the-risk
Investopedia. (2018a). Bond ratings. investopedia.com. Retrieved on 12 October 2018 from https://www.investopedia.com/walkthrough/corporate-finance/3/bonds/ratings.aspx
Investopedia (2018b). AAA. Investopedia.com . Retrieved on 12 October 2018 from https://www.investopedia.com/terms/a/aaa.asp
Nelson, B. (2017). What is a BBB credit rating? Pocketsense.com. Retrieved on 12 October 2018 from https://pocketsense.com/what-bbb-credit-rating-4620111.html
Wilkinson, J. (2013). Credit rating agencies. Strategiccfo.com. Retrieved on 12 October 2018 from https://strategiccfo.com/credit-rating-agencies/
