How does the bond rating affect an investor's required rate of return? What factors affect a bond's rating?
What will be an ideal response?
Ratings involve a judgment about the future risk potential of the bonds. Although they deal with expectations, several
historical factors seem to play a significant role in their determination. Bond ratings are favorably affected by 1. a
greater reliance on equity as opposed to debt in financing the firm, 2. profitable operations, 3 . a low variability in
past earnings, 4. large firm size, and 5. little use of subordinated debt. In turn, the rating a bond receives affects the
interest rate demanded on the bond by the investors. The poorer the bond rating, the higher the interest rate demanded
by investors. Thus, bond ratings are extremely important for the financial manager. They provide an indicator of
default risk that in turn affects the interest rate that must be paid on borrowed funds.
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