What is usually the relationship between a bond’s rating and the interest rate a company pays to buyers?
A. The rating is the same as the rate.
B. The higher the rating, the lower the rate.
C. There is no relationship.
D. The higher the rating, the higher the rate.
I'll be glad to check your answer.
Right.
The correct answer is B. The higher the rating, the lower the rate.
When a company issues bonds, they are assigned a rating by independent credit rating agencies such as Moody's, Standard & Poor's, and Fitch. These ratings assess the creditworthiness of the company and indicate the likelihood of the company defaulting on its bond payments.
The rating agencies assign different ratings ranging from AAA (highest rating) to D (default rating) or lower. Bonds with higher ratings are considered to have lower credit risk and therefore, will attract more investors.
Since investors are more confident in the repayment ability of companies with higher ratings, they demand lower interest rates or yields on these bonds. On the other hand, companies with lower ratings are considered to have higher credit risk, and thus, they need to offer higher interest rates to attract investors and compensate for the additional risk.
This relationship between bond ratings and interest rates is known as the "credit spread." A credit spread represents the additional interest rate required by investors to hold bonds with lower ratings compared to bonds with higher ratings. So, the higher the rating, the lower the interest rate a company pays to buyers.