Bonds are not the easiest investments to figure out. A bond fund, apart from its description, doesn’t tell us much about all the risks involved either. In an environment where investors chase higher yields, the greater risk of loss can be quickly ignored. Bond ratings make it easy for investors to understand the default risk of a bond, while still taking into account all the other risks.
What Are Bond Ratings?
Bond ratings are just credit scores for governments and companies. It measures the issuer’s financial strength and ability to make interest and principle payments to bondholders. For investors, these grades are an easy way to do a credit check without digging into financial statements.
The ratings are easy enough to understand. The higher the bond rating, the lower the risk of default. It also means a lower cost to borrow for the company and a lower interest rate on the bond.
If the issuer’s credit score changes, the bond ratings will change with it. If investors view the change as good, it will increase demand and raise the price of the bond, lowering the interest rate. Of course, the opposite could happen or nothing could happen. It all depends on whether investors the ratings change positively or negatively.
In order to understand investor sentiment, we need to know the bond rating scale. Which is made up of a combination of letter grades. If you understood the letter grading scale in school, this should be easy.
Bond Rating Scale
The three main ratings agencies are Standard & Poor’s, Moody’s and Fitch. There isn’t a standard ratings system between each ratings agencies. Standard & Poor’s and Fitch use a similar ratings scale. Moody’s complicated things in their effort to differentiate themselves. So we have three ratings agencies with different ratings scales. Each one based on the agencies unique grading criteria.
The highest ratings (AAA to BBB-) are considered investment grade bonds. These are Treasuries and high quality municipal, corporate and foreign bonds.
Anything lower (BB+ and lower) are non-investment grade, consisting of high yield or junk bonds. With the higher yields brings more risk. With each lower grade brings a greater risk of default. An easy way to remember it is A’s are good, B’s are average risk and C’s or lower are very risky.
|Moody’s||Standard & Poor’s||Fitch||Notes|
|Aaa||AAA||AAA||Highest investment grade|
|Baa3||BBB-||BBB-||Lowest investment grade|
|Ba1||BB+||BB+||Highest non-investment grade|
|Caa2||CCC||High risk of default|
|C||C||Lowest quality, highest risk|
Why Ratings Matter
A ratings system is an easy way of judging the financial strength of an issuer. This isn’t hard to find out for companies. Just dig through the balance sheet and you’ll discover this soon enough. But what about municipal or foreign bonds. When financial strength is based on tax revenue or transparency isn’t a priority, getting this information is difficult.
These ratings make the process easier for bond investors. As interest rates fluctuate, it’s easy for investors to seek higher yields without understanding the risks involved. So you can quickly match a bond or bond fund to your risk profile just by checking the rating.
This also comes in handy for stock investors. When you research stocks, you can quickly check a company’s bond rating to get an idea of its financial strength. And decide if you want to pass on the stock or not. It’s an easy way to streamline the research process.
Of course, for all this to be relevant, the ratings agencies must be accurate. This doesn’t mean you should ignore the ratings entirely. Just use the bond ratings as a basic default risk guide and be aware of any rating changes.