What is AAA Bond

The recent market correction has shifted the choice of investment from equity to debt instruments. Irrespective of the type, investment decisions are a trade-off between the potential rewards and risk involved and each investment is subject to some risk.

Analysts use fundamental and technical analysis for decision-making. While adequate research is imperative for equity and debt investing, ratings assigned to debt instruments assist in decision-making. This article highlights one type of debt investment: AAA bonds.

AAA Bond

Bonds are conventional debt instruments. Investors purchase bonds in anticipation of interest and principal repayment in the future. Although, there is a likelihood of default on the payment. Credit rating agencies assign grades to bonds based on the likelihood of default by the issuer. AAA bonds are the highest-rated and safest bonds. Ratings range from AAA to C and D.

Credit rating agencies evaluate various factors to determine the safety of bonds. These include the issuer's financial strength, future cash flows to cover interest and principal, collateral assets, and securities in case of default.

Bond ratings are dynamic and change based on the issuer's financial position. In the economic crisis of 2008, companies such as General Electric lost their AAA rating.

What is AAA bond yield?

The fundamental rule of finance is higher the risk, the greater the reward. The risk involved in AAA bonds is low, so AAA bond yields is relatively low. Capital protection and regular, periodic income are essential for an AAA investor. Junk bonds or bonds with lower credit ratings have high yields. Issuers for these bonds have a high default risk or have defaulted in the past.

Investors must determine the ideal investment option based on individual investment objectives and risk appetite. AAA bond funds, a mixed bag of bonds, help to diversify risk and maximize returns.

Benefits of AAA Bonds

For an issuer, a high credit rating reduces the borrowing cost. Companies with high credit ratings can borrow more easily than companies with lower credit ratings. However, companies with more access to capital have a competitive advantage that enables rapid growth.

A company may use borrowed capital for marketing, launching a new product, acquiring a competitor or expansion. These endeavours help the company increase its market share and support long-term growth.

Types of AAA Bonds

• Government Bonds

  The risk involved with government securities is the lowest since the government can levy taxes to meet its debt obligations. The possibility of government default is a bare minimum.

  Government issues bonds as revenue or general obligation bonds. Government funds revenue bonds using fees or income-generating activities such as tolls, public transport, services, etc. In contrast, general obligation bonds operate on the issuer's creditworthiness.

• Secured and Unsecured Bonds

  Bonds may be secured or unsecured. Typically, secured bonds of a company are rated higher than unsecured bonds. An asset or collateral backs a secured bond. Companies use tangible objects such as machinery, equipment, or real estate as collateral. The creditor has a claim on the collateral if the issuer defaults. Unsecured bonds rely on the income-generating and cash flow position of the issuer.

• Alternatives to Triple- A(AAA) Bonds

  AAA bonds have their place in the broader category called investment-grade bonds. Investment-grade bonds include any bonds rated at or higher than BBB-. Financial institutions such as trusts and pension funds prefer investment-grade bonds over lower-grade bonds to provide capital safety and fixed income.

  Government securities such as treasury bills and commercial papers are the safest form of bonds. Similarly, blue-chip companies' convertible debenture and preference shares are relatively safe with average returns.

Bottom Line

AAA bonds in India include government securities, deposits with established companies, and secured debentures. However, debt instruments are ideal for diversification and versatile for each investor type.