Once you build your investment capital and begin investing in bonds, you are likely to hear about bond credit ratings like Triple-A (AAA) bonds. This designation might seem confusing but it comes down to understanding how “safe” a bond is by looking at all sorts of metrics, such as the strength of the issuer’s balance sheet, the likelihood of sufficient earnings and cash flows to cover the promised interest and principal repayments, and the collateral that can be seized in the event the bond defaults before or at bond maturity.
What is AAA Bond Rating?
A bond rating assigned to an investment grade debt instrument. AAA is the highest possible rating and reflects an opinion that that the issuer has the current capacity to meet its debt obligations and has an extremely low solvency risk from changes in business, financial, or economic conditions.
Bond investors rely on bond ratings from organizations like Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings to evaluate the default risk associated with both corporate bonds and municipal bonds.
Each agency uses a different methodology to measure creditworthiness and uses a specific rating scale. So the rating is the agency’s opinion of relative level risk of Credit Risk that the issuer carries from strongest to weakest within a universe of credit risk. So one point to note here is that AAA rating is not a guarantee that the borrower would never default, instead there is less chance of defaulting of AAA rated issuer that of a BBB rated issuer. The main implication here is that an AAA rated borrower usually secures loans at lower interest rate as they are perceived to be able to repay the debt without default.
Where does the AAA Rating Come From?
Rating agencies date back to the 19th century, and the heady early days of the US railways. In the rush to lay track and build railway stations across the American continent, investors craved information to help them profit without losing their shirts. Many railway companies went bankrupt, with some businessmen – among those later dubbed “robber barons” – using borderline-illegal tactics to cripple their rivals.
Henry Varnum Poor (one of the “fathers” of Standard & Poor’s (S&P) credit-rating agencies) was one of the first analysts to tackle the railway tycoons. He collected and published analyses of the financial health of the various railroad companies that sprang up across the country. John Moody launched a similar venture, called Analyses of Railroad Investments, in the early 20th century.
Fitch says it was the first agency to create an alphabetical ranking for bonds issues by countries, called sovereign debt, and corporations in 1924. Fitch, Moody’s and S&P, in 1975, became the first three companies to be recognised as “statistical rating agencies”. Today, there are 10 rating agencies approved by the US securities and exchange commission.
What is special about the AAA rating?
The “triple A” rating is the highest possible rating that can be given to a company or country. S&P says that it only awards AAA when there is an “extremely strong capacity to meet financial commitments”. This gold standard means an AAA-rated borrower can usually secure a loan at lower interest rates, as there is much less risk that the money will not be repaid.
A company or government can find that it’s credit rating can impact on it’s ability to borrow money. High credit ratings, like AAA, mean it is usually easier to find investors willing to lend to them. However, a low credit rating means it’s seen as a greater risk, and it may have to offer investors higher returns.
AAA ratings are highly sought after, since they allow companies to borrow larger sums of money. Because of their attractiveness to investors, bonds with these ratings don’t need to offer particularly high yields.
Further Explanation of the AAA Rating
Investors look at the rating of a bond to assess whether they want to invest in it. Higher rated bonds are considered safer, and therefore the issuer typically provides smaller interest payments. Less credit worthy companies and countries need to pay higher interest rates in order to attract investors, as investors want to be compensated with a higher return for the increased risk they are taking in a buying a lower quality bond.
The AAA rating and AA are high quality bonds, also known as investment grade. You are very likely to receive your money back, with interest, but the interest paid is usually lower than what you will see in lower rated bonds.
A to BBB are medium quality bonds. Interest you receive is likely to be a bit higher than a comparable AAA rating or AA bond.
BB down to C are lower quality bonds, referred to as “junk bonds.” Companies and countries in this category typically offer higher interest payments than companies and countries with a higher rating. While there is more risk in this category, there is a the possibility of finding some “diamonds in the rough.” With some research investors can receive more interest and help reduce their risk by investing in a basket of junk bonds they feel offer reasonable assurance of payment. Keep in mind, if something sounds too good to be true, it probably is. Companies and countries don’t offer massive interest payments unless they are desperate, and a company or country in a desperate situation isn’t the most reliable place to invest capital. Assess whether the reward is worth the risk.
D is a category reserved for companies or countries already in default on some of their debts. The average investor has little need to look for investments in this category, and hopes that their current investments don’t reach a D rating.
Rating are somewhat controversial because credit rating agencies are often slow to react when conditions within a company or country change. The credit rating agencies didn’t see the risk during the 2008 financial crash, maintaining high ratings on companies that ended going bankrupt or required government bailouts. Doing some of your own research, and not implicitly trusting others, is always advised.
Types of AAA Bonds
Municipal Bond Types
Municipal bonds can be issued either as revenue bonds or as general obligation bonds—with each type relying on different sources of income. Revenue bonds, for example, are paid using fees and other specific income-generating sources, like city pools and sporting venues. On the other hand, general obligation bonds are backed by the issuer’s ability to raise capital through levying taxes. Pointedly: state bonds rely on state income taxes, while local school districts depend on property taxes.
Secured vs. Unsecured Bonds
Issuers can sell both secured and unsecured bonds. Each type of bond carries with it a different risk profile. A secured bond means that a specific asset is pledged as collateral for the bond, and the creditor has a claim on the asset if the issuer defaults. Secured bonds may be collateralized with tangible items such as equipment, machinery, or real estate.
Secured collateralized offerings may have a higher credit rating than unsecured bonds sold by the same issuer. Conversely, unsecured bonds are simply backed by the issuer’s promised ability to pay, therefore the credit rating of such instruments relies heavily on the issuer’s income sources.
Investment-Grade Bonds and Treasuries
AAA bonds belong to a broader category of bonds known as “investment-grade” bonds. Investment-grade bonds include any bond that is rated at or above BBB- (on the S&P and Fitch scale) or Baa3 (on the Moody’s scale). This has important regulatory implications. For example, a bank trust department or pension fund may favor investment-grade bonds over lower-grade bonds.
The grading system can break down slightly when comparing investment-grade corporate bonds to government bonds like Treasury Bills and Treasury Notes—also known as “Treasuries.” Even though a company like Microsoft may be able to issue AAA bonds, U.S. Treasuries are generally considered the safest bonds. That’s because they carry the full weight of the U.S. government behind them.
Not all government bonds are as safe as Treasuries. Municipal bonds (munis) are issued by lower-level government bodies. They can be issued by state authorities, cities, or agencies like a school district. They can also be issued by U.S. territories like Puerto Rico. Since these bonds aren’t issued by the federal government, they aren’t backed by the federal government. The relative safety of municipal bond investments varies by the entity issuing them.
Benefits of a AAA Rating
A high credit rating lowers the cost of borrowing for an issuer. Therefore, it stands to reason that companies with high ratings are better positioned to borrow large sums of money than fixed-income instruments with lesser credit ratings. And a low cost of borrowing affords firms a substantial competitive advantage, by letting them easily access credit to grow their businesses.
For example, a business may use the incoming funds from a new bond issue to launch a new product line, set up shop in a new location, or acquire a competitor. All of these initiatives can help a company increase its market share, and thrive over the long haul.