I’m a researcher in the fields of sociology and historical public policy, and I am bad, bad, bad with numbers, so I don’t understand economic principles very well. But my current research is leading me ever deeper into economics, specifically topics that I’m super unfamiliar with, and I need help getting a basic understanding of a couple of key principles so I can understand what I’m reading:
What ARE corporate bonds, actually? And what’s the relationship between credit agencies that rate those bonds and the value of the bonds? Why is that important to markets and the economy?
EDIT (follow up question): what impact would it have on a country’s economy / society / innovation if they had an unreliable or underdeveloped enterprise credit rating industry?
Any insight from you smart econ people would be amazing.
In: Economics
Corporate bonds are formalized loans from you to the corporation. You buy the bond, they pay interest on it and have to pay the balance at maturity.
Credit rating agencies opine about how likely the corporation is to pay the bond back.
The value of the bond can be thought of in terms of its total yield, multiplied by the percentage chance that it will be paid back. The lower the probability of repayment, the higher the interest the bonds have to yield in order to interest investors.
So if I buy a $10k bond at 3% for ten years from a company with a triple-A rating, meaning it had almost 100% likelihood of paying it back, the value of the bond is almost $13,000. If I buy a $10k bond at 25% for ten years from a company with a junk rating that is only 50% likely to pay it back, the value of the bond is $17,500. Which is the better investment depends on your personal risk tolerance and your overall investment strategy.
So, the credit rating agency impacts the valuation of the bond by informing investors’ perception of the likelihood of repayment, which impacts what interest rates they need to be getting in order to make the risk worth it.
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