Bond Rating

What is a Bond Rating?

A bond rating is a graded evaluation of an bond issuer’s default risk designated by a letter grade of AAA through D illustrating the bond’s overall credit quality. In other words, it is a score that is assigned to a bond as an indication of its reliability and potential fulfillment of terms, conditions and payments.

A bond credit rating represents the credit worthiness of corporate or government bonds. It is not the same as an individual’s credit score. The ratings are published by credit rating agencies and used by investment professionals to assess the likelihood the debt will be repaid.

A bond rating is a measure of the likelihood of a bond’s default. Credit ratings agencies conduct credit analysis in order to provide bond ratings; the criteria and the ratings themselves may change these from time to time. Bond ratings are important to bond investors as they make investment decisions. For example, if a bond has a low rating and an investor is risk averse, he/she will be unlikely to invest in that bond, as it will lead to an increased possibility that the investor will lose the amount invested.

A bond rating is a way to measure the creditworthiness of a bond, which corresponds to the cost of borrowing for an issuer. These ratings typically assign a letter grade to bonds that indicates their credit quality. Private independent rating services such as Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings Inc. evaluate a bond issuer’s financial strength, or its ability to pay a bond’s principal and interest, in a timely fashion.

What Does Bond Rating Mean?

Rating agencies are in charge of evaluating and assessing a bond’s rating. These entities evaluate a bond issuer’s financial strength and its ability to pay a bond’s principal and interest by thoroughly reviewing its financial statements and business conditions. Bond ratings are very important for investors because they inform them about the stability and quality of the bond; thus, ratings affect a bond’s price, its yield, and its appeal for investors.

These ratings are often classified using three letters from AAA to D. The highest graded bonds are called investment grade bonds and are usually graded from AAA to BBB- ratings. These bonds are of the highest quality and are the least likely to default on a principal or interest payment during their life.

The more risky bonds, also known as junk bonds, are given a C or D rating. These junk bonds will have to pay more interest to investors to compensate them for the risk associated with the companies’ poor financial performance.

Some rating services use the same letter grades but use upper and lower-case letters. This rating system is taken into consideration by almost all investors since it indicates the likelihood that the issuer will default in a given period of time, either on interest or principal payment.

Understanding Bond Ratings

Thousands of government agencies and private companies look to raise capital by issuing debt, and the bonds that they sell are popular investments among those looking for fixed income. However, the depth of the bond market can make it difficult for investors to assess whether one company is more or less likely to repay its debt than another. In order to simplify comparison of different bonds, bond-rating agencies make it their specialties to issue bond ratings for different bonds.

Bond ratings use a combination of letters, numbers, and symbols to indicate their relative placement on a given agency’s rating scale. Letters generally indicate a broad range of ratings. Having more letters in the rating is generally better than fewer letters, and being earlier in the alphabet indicates higher quality.

For Standard and Poor’s, AAA is the best rating, followed by AA, A, BBB, BB, B, CCC, CC, and C. D is used for bonds that are already in default. Fitch’s ratings are similar to S&P. Moody’s uses a slightly different scale, but its Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C ratings have roughly the same meaning.

From there, numbers or symbols further break down the letter-based rating. For example, with S&P and Fitch, a rating of AA+ is better than AA, and a rating of AA- is worse than AA, but better than A+. Moody’s uses numbers to indicate relative quality, with Aa1 being the best Aa rating, followed by Aa2 and Aa3.

Rating Factors

The bond rating agencies look at specific factors including:

  • The strength of the issuer’s balance sheet. For a corporation, this would include the strength of its cash position and its total debt. For countries, it includes their total level of debt, debt- to-GDP ratio, and the size and directional movement of their budget deficits.
  • The issuer’s ability to make its debt payments with the cash left over after expenses are subtracted from revenue.
  • The condition of the issuer’s operations. For a corporation, ratings are based on current business conditions including profit margins and earnings growth, while government issuers are rated in part based on the strength of their economies.
  • The future economic outlook for the issuer, including the potential impact of changes to its regulatory environment, industry, ability to withstand economic adversity, tax burden, etc., or in the case of a country, its growth outlook and political environment.

Standard & Poor’s ranks bonds by placing them in 22 categories, from AAA to D. Fitch largely matches these bond credit ratings, whereas Moody’s employs a different naming convention.

In general, the lower the rating, the higher the yield since investors need to be compensated for the added risk. Also, the more highly rated a bond the less likely it is to default.

S&P Global Bond Ratings

Standard & Poor’s (S&P) is the oldest credit rating agency and one of the three Nationally Recognized Statistical Rating Organizations (NRSRO) accredited by the U.S. Securities and Exchange Commission. The company covers more than one million credit ratings on government and corporate bonds, structured finance entities, and securities.

S&P issues both long-term and short-term bond ratings. The main goal of the S&P credit rating is the assessment of a security’s default probability.

RatingDescriptionGrade
AAAExtremely strong capacity to meet financial obligations.Investment
AAVery strong capacity to meet financial obligations.Investment
AStrong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.Investment
BBBAdequate capacity to meet financial commitments, but more subject to adverse economic conditions.Investment
BBLess vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.Speculative
BMore vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.Speculative
CCCCurrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.Speculative
CCHighly vulnerable; default has not yet occurred but is expected to be a virtual certainty.Speculative
CCurrently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.Speculative
DPayment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken.Speculative
NRThe security was not rated.

Moody’s Investors Service Bond Ratings

Moody’s is another credit and bond rating agency accredited by NRSRO. The company covers more than 135 sovereign nations, 5,000 non-financial corporate issuers, 4,000 financial institutions, 18,000 public finance issuers, 11,000 structured finance transactions, and 1,000 infrastructure and project finance issuers. Unlike S&P and Fitch, the primary purpose of Moody’s ratings is the evaluation of projected losses in case of a default.

RatingDescriptionGrade
AaaObligations of the highest quality, with minimal risk.Investment
AaObligations of high quality, with very low credit risk.Investment
AObligations of upper-medium-grade, with low credit risk.Investment
BaaObligations of moderate credit risk that may possess speculative characteristics.Investment
BaObligations with speculative elements that are subject to substantial credit risk.Speculative
BObligations are considered speculative that are subject to high credit risk.Speculative
CaaObligations of poor standing and are subject to very high credit risk.Speculative
CaHighly speculative obligations that are likely in, or very near, default, with some prospect of recovery in principal and interest.Speculative
CLowest-rate class of obligations that are typically in default, with little prospect of recovery of principal and interest.Speculative

The numerical modifiers can be added to the existing rating categories from Aa to Caa. The number 1 indicates that the obligation is ranked at the higher end of the rating category, 2 indicates a mid-range ranking, and 3 indicates the lower end of the rating category.

Fitch Ratings

Fitch is the smallest credit rating agency among the “Big Three” agencies. The firm covers several different sectors, including financial institutions, insurance companies, sovereigns, corporate finance, structured finance, Islamic finance, and global infrastructure. However, Fitch’s market share is limited relative to that of its bigger rivals.

Similar to S&P, the main purpose of Fitch’s rating is the assessment of a security’s default probability. It also uses a bond ratings scale similar to that of S&P.

RatingDescriptionGrade
AAAExtremely strong capacity to meet financial obligations.Investment
AAVery strong capacity to meet financial obligations.Investment
AStrong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.Investment
BBBAdequate capacity to meet financial commitments, but more subject to adverse economic conditions.Investment
BBLess vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.Speculative
BMore vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.Speculative
CCCCurrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.Speculative
CCHighly vulnerable; default has not yet occurred but is expected to be a virtual certainty.Speculative
CCurrently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.Speculative
DPayment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken.Speculative
NRThe security was not rated.

Why Bond Ratings Matter

Bond ratings have a huge influence on the price and demand for certain bonds. The lower the rating, the riskier the investment and the less the investment is worth. Low bond ratings often lead to less trading activity and thus liquidity problems. This is why downgrades (or rumors of downgrades) in an issuer’s credit rating can have a significant impact on its bonds and on the market or industry.

Low bond ratings are not always bad. They simply mean there is more risk associated with a bond and thus, more potential for higher returns. In fact, many income investors actively enhance their returns by dividing bonds into sectors based on certain characteristics such as credit rating, yield, coupon, maturity, etc. They then find those sectors that will perform most favorably for the investor under certain market conditions.

Do Bond Ratings Change?

A bond rating is not a static assessment that sticks with a bond over the course of its life. Some bonds are issued with maturities of 10 years, 20 years or even 30 years or more. Over such long periods of time, the financial conditions of the underlying entities are likely to change, for better or worse.

After issuing an initial rating, agencies continually monitor the financials of bond issuers. If a bond issuer encounters financial difficulty and is less likely to be able to make bond payments, a downgrade may be issued. Similarly, if a company makes financial progress and become more financially sound, it may find that its bonds receive an upgrade.

Bond Upgrades and Downgrades

Upgrades and downgrades are important for both the bond issuer and for investors. Bond issuers can end up paying less interest after a rating upgrade, while bond investors can see some price appreciation after an upgrade.

For bond issuers, a rating upgrade means they can issue future debt under the upgraded rating. Higher-rated bonds typically pay lower rates of interest, so a company or government entity can benefit in the form of lower interest costs. These new bonds can be used to either finance future growth at a lower interest rate or to pay off older bonds that were issued at higher interest rates.

For example, let’s say a company rated BBB issues a bond that pays 6 percent interest. All other things being equal, if the company sees an upgrade to A, they may be able to issue a bond paying just 5 percent interest. On a $10 million bond issue, one single percentage point of interest amounts to an additional $100,000 in interest per year, so refinancing that debt at a lower rate could be a good financial move.

From the perspective of an investor, a rating upgrade is a good thing because it can often translate into price appreciation, as higher-rated bonds are more in demand. Imagine two bonds rated CCC that are both paying the same 6 percent interest rate. If one of those bonds was upgraded to BBB, investors would gravitate toward it because it is safer in the eyes of the rating agencies; in other words, it’s more likely that you’ll get your interest and principal payments from the higher-rated bond, making it more valuable.

When investors buy more of a bond, the price tends to go up until it approximates the yield of other bonds with a similar rating. Although the stated interest rate would remain the same, the yield to maturity – or the total value of payments you would receive from a bond, including both interest and price appreciation – would go down.

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