Why Are Bond Ratings So Important to Companies?
When a corporation issues a bond, credit rating agencies rate it as to the safety of principal and interest based on the company's ability to pay. Credit ratings are important to investors because the higher the rating, the safer the bond. But credit ratings are also important to the issuers because they may affect the cost of doing business, access to capital and executive compensation.
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Interest Expense
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The higher the credit rating, the less interest a corporation has to pay on its bonds because investors are willing to accept slightly lower interest for more safety. Bond interest remains fixed for the life of the bond. If the financial conditions of the company later deteriorate and credit rating agencies lower their ratings on the bond, the change may negatively impact its price in the secondary market but the interest payments won't change. However, if the corporation is looking to issue more bonds, those will get the lower rating and will have to be issued with higher interest.
Marketability
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The higher a bond's rating, the more demand there is for a bond and the easier it is for a corporation to sell it. Corporations with the highest credit ratings can also raise more money that way.
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Refinancing and Other Problems
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Many corporations use debt as a permanent source of capitalization, meaning that when a bond issue matures, they refinance it with another one right away in order to keep the funds. If the credit rating has been lowered, a corporation may not be able to refinance at all, which may jeopardize ongoing operations. Some corporations also borrow from banks. Bank debt may have several provisions attached, including a requirement to maintain the credit rating above a certain level. If the credit rating drops below that level, it may trigger all sorts of clauses in the company's bank debt. These could include cancellation of a revolving credit facility or a demand for immediate repayment of all outstanding balances.
Stock Investor Concerns
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Credit rating reflects the general financial condition of a corporation. When a credit rating is lowered, it tells the stock investors that a company's financial condition is deteriorating. Some may sell the stock as a precaution, or at least abstain from buying more. The selling pressure and/or reduced demand may depress the stock price and make it more difficult for a corporation to sell more stock to raise capital.
Executive Compensation
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Company executives may own substantial amounts of stock and/or hold a lot of stock options. A lower stock price means a drop in the executives' personal net worth and inability to exercise stocks options.
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