ACCA Advanced Financial Management (AFM) Practice Exam

What is the purpose of bond ratings?

1. To determine the investment value of the bonds

2. To assist investors in assessing default risk

3. To set interest rates for bonds

4. To indicate market demand for bonds

The correct answer is: To assist investors in assessing default risk

Bond ratings serve a crucial role in the financial markets by providing an assessment of the default risk associated with a bond issuer. The primary purpose of these ratings is to give investors a clear indication of the likelihood that the issuer will default on its debt obligations, which means failing to make the required interest payments or repay the principal amount upon maturity. When investors evaluate bonds, they are particularly concerned about the safety of their investment and the consistency of returns. High-quality ratings suggest a lower risk of default, making such bonds a safer investment choice, often attracting risk-averse investors. Conversely, lower-rated bonds indicate higher risk, which may yield higher returns to compensate for the increased chance of default. This system of rated classifications aids investors in making informed decisions by comparing the relative risk levels of different bonds, thereby enhancing transparency in the bond market. The other options, while related to bond investing, do not capture the core function of bond ratings as effectively. For instance, determining the investment value of the bonds or setting interest rates pertains more to broader market dynamics and investor perceptions rather than the specific purpose of ratings. Indicating market demand relates to how well a bond might sell in the market but does not directly address the risk of default, which is central to