A bond rating is a measurement that indicates how secure a bond is. In other words, it tells you the creditworthiness of a bond by assigning a letter grade to the bonds for showing the bond’s credit quality.
Given in terms of alphabets, many rating agencies issue bond ratings for various bonds available in the market. The bond ratings allow the investor to evaluate the financial capabilities of the bond issuers, which helps them invest wisely.
Bond-rating agencies like Standard & Poor’s assign “AAA” to “BBB” ratings to investment-grade bonds while another ratings agency Mood’s assign Aaa to Baa3 ratings to an investment-grade bond.
Table of Contents
What is a bond rating?
Definition: A bond rating is defined as a letter-based credit scoring used by bond-ratings agencies to measure the quality of a bond and find out investment-grade and non-investment-grade bonds. It tells about the bond issuer’s financial strength, credit quality, and credit ratings.
The timely payment of the bond’s face value and the interest levied on it is predicted by the bond’s rating, which is ultimately the bond issuer’s ability to pay back. The bond rating depicts the trustworthiness of corporate or government bonds. The creditworthiness of a bond shows how much a bond issuer can be trusted to pay back the amount on time.
How Bond Ratings Work?
Every bond issuer has a report that showcases their creditworthiness. Still, in addition to that, they have some particular rating agencies that evaluate their ability to deliver on their contract when the bond matures. Corporations like Moody’s, Standard & Poor’s, and Fitch publish their reports in which the companies are judged on their financial strength, which helps the investors to choose among them.
The agencies’ report on their creditworthiness plays a vital role in figuring their bond’s yield. A bond yield is an investor’s return, and the issuer has to pay for borrowing the money. A lower rating given by a rating agency has to be taken care of by offering a higher yield. Similarly, a higher bond rating provides the issuer with an opportunity to give low results on their bond.
- Bond ratings are published in letters that act like scores used to represent the bond’s creditworthiness, that is, their ability to pay back the amount and the interest on it on time.
- As discussed before, a lower rating needs a higher yield, which means that if a bond’s rating is low, the issuer would have to offer high interests to lure investors and vice-versa.
- Every agency has a different way of rating bonds through letters. For example, Standard & Poor’s ratings range from AAA to BBB and Moody’s from Aaa to Baa.
Popular Bond Rating Agencies
Three companies, Moody’s, S&P, and Fitch, cover almost 95% of the bond rating market. Each of these agencies has its rating procedure, but what sets a common ground are the bases on which they grade.
Bonds are judged on quality and risk by all three of them, wherein the sub-criteria in quality are investment, non-investment, and not rated. Similarly, the risk category contains ratings from default to the highest quality.
As the name suggests, the investment-grade bonds under quality are the ones that are safe for investors to trust and put their money in. Non-investment, on the other hand, are the ones whose risk factor is on a larger scale, which is also why they provide high yields.
The bond ratings calculated by experts come in handy for investors when they find themselves choosing between bonds with different contractual conditions.
1. Standard & Poor’s
Grading more than a million bonds, including both government and corporate ones, Standard & Poor’s is one of the earliest companies to help investors make wise investing decisions.
Short-term and long-term ratings are both issued by the U.S. Securities and Exchange Commission accredited company, one of the National Recognized Statistical Rating Organizations.
| AAA | Extreme capacity to meet financial obligations | Investment |
|---|---|---|
| A.A. | Powerful capacity to meet financial obligations | Investment |
| A | Strong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances. | Investment |
| BBB | Adequate capacity to meet financial obligations, but more susceptible to adverse economic conditions and changes in circumstances. | Investment |
| BB | Less vulnerable in the near-term but faces significant ongoing uncertainties to adverse business, financial and economic conditions. | Speculative |
| B | More vulnerable to adverse business, financial, and economic conditions but can currently meet financial commitments. | Speculative |
| CCC | Currently Vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments. | Speculative |
| CC | Highly vulnerable, default hasn't occurred yet but is expected to be a virtual certainty. | Speculative |
| C | Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than the higher-rated obligations. | Speculative |
| D | Payment on a financial commitment or breach of an imputed promise is also used when a bankruptcy petition is filed, or similar action is taken. | Speculative |
| N.R. | Not rated |
2. Moody’s Investors Service
Covering the bonds of more than 135 nations, 5000 non-financial corporate issuers, 4000 financial institutions, 18000 punic finance issuers, 11000 structured finance transactions, and 1000 infrastructure and project finance issuers, Moody’s is another one of the NRSRO.
The only thing that this agency takes care of is the representation of possible losses in case of a default.
| Aaa | Obligations of the highest quality, with minimal risk | Investment |
|---|---|---|
| Aa | Obligations of high quality, with shallow credit risk | Investment |
| A | Obligations of upper-medium grade, with low credit risk | Investment |
| Baa | Obligations of moderate credit risk that may possess speculative characteristics | Investment |
| Ba | Obligations with speculative elements that are subjected to substantial credit risk | Speculative |
| B | Obligations are considered speculative that are subject to high credit risk. | Speculative |
| Caa | Obligations of poor standing and are subject to very high credit risk | Speculative |
| Ca | Highly speculative obligations that are likely in, or very near, default, with some prospect of recovery in principal and interest | Speculative |
| C | Lowest-rate class of obligations that are typically in default, with little prospect of recovery of principal and interest | Speculative |
Along with the alphabets, numbers are also used by Moody to grade the bonds. Numbers 1, 2, and 3 can be placed with every rating ranging from Aaa to Caa, where 1 depicts the highest category, two mid-range, and three the lowest rating among them.
3. Fitch Ratings
Fitch is the third one of the three rating agencies that come under the accreditation of NRSRO and are commonly known as the ‘big three. Unlike the other two, the bonds covered by Fitch are limited compared to the market share of the other two.
Bonds belonging to various sectors, including corporate, finance, insurance, etc., are similarly graded by Fitch to S&P. Also, just like S&P, Fitch’s central area is the bond’s default probability.
| AAA | Extremely strong capacity to meet financial obligations | Investment |
|---|---|---|
| A.A. | Very strong capacity to meet financial obligations | Investment |
| A | Strong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances | Investment |
| BBB | Adequate capacity to meet financial obligations, but more susceptible to adverse economic conditions and changes in circumstances | Investment |
| BB | Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions. | Speculative |
| B | More vulnerable to adverse business, financial, and economic conditions but can currently meet financial commitments. | Speculative |
| CCC | Currently Vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments. | Speculative |
| CC | Highly vulnerable, default hasn't occurred yet but is expected to be a virtual certainty. | Speculative |
| C | Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than the higher-rated obligations. | Speculative |
| D | Payment on a financial commitment or breach of an imputed promise is also used when a bankruptcy petition is filed, or similar action is taken. | Speculative |
| N.R. | Not rated | |
Importance of Credit Rating
The ratings given by the agencies are used to categorize the bonds so that it becomes easier for an investor to compare all types of bonds. Bonds with rating BBB- (S&P and Fitch) and Baa3 (Moody’s) or higher come under the investment grade while the rest of them are speculative.
S&P and Fitch use the plus and minus sign (-, +) to rank a category, and Moody uses numerical figures (1-3). In the case of S&P and Fitch, C+ is better than C while C is better than C-. Also, according to Moody’s ratings, B1 is better than B2 but still worse when compared to Ba3.
Investment Grade and High-yield bonds
Investors generally classify the bond ratings into 2 types-
- Investment-grade for the bonds that are rated Baa3/BBB- or better.
- High-yield for the non-investment-grade or junk bonds that are generally rated Ba1/BB+ and lower
Investment-grade bonds have higher bond ratings and they comprise lower credit risk.
The high-yield bonds are those whose ratings are low. Therefore, only an experienced investor who can tolerate substantial credit risk is worthy enough of investing in high-yield bonds or junk bonds.
High-yield bonds are riskier to invest in because of the lack of capabilities of their issuer to repay the principal and interest.
Conclusion!
The financial capabilities of the issuer are the biggest factor that can cause a change in the bond’s rating.
Therefore, whether you have municipal bonds or corporate bonds, their ratings can be downgraded or upgraded by a bond rating agency. Hence, it is essential to pay heed to the bond’s rating in a regular manner.
How important do you consider bond ratings in differentiating bonds with very low credit risk, very high credit risk, and moderate credit risk?
