How Bond Ratings Work

Bond RatingsBonds are not the easiest investments to figure out. A bond fund, apart from its description, doesn’t tell you 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 you to understand the default risk of a bond, while still taking into account all the other risks.

What Are Bond Ratings?

Bond ratings are 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. For that, the company gets a lower cost to borrow. For you, it’s a lower interest rate on the bond, but a higher chance you’re paid in full.

A bond’s rating will change as the issuer’s credit score changes. When 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 depends on whether investors see the change as positive or negative.

In order to understand investor sentiment, you need to know the bond ratings scale, which is made up of a combination of letter grades. If you understand the letter grades in school, this should be easy.

Bond Ratings Scale

The three main ratings agencies are Standard & Poor’s, Moody’s and Fitch. There isn’t a standard ratings system between each agencies. Standard & Poor’s and Fitch use a similar ratings scale. Moody’s complicated things in their effort to differentiate themselves. So you have three ratings agencies with different scales. Each one based on the agency’s 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. The risk default rises with each lower grade. Here’s an easy way to remember it: 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
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA- AA-
Baa1 BBB+ BBB+
Baa2 BBB BBB
Baa3 BBB- BBB- Lowest investment grade
Ba1 BB+ BB+ Highest non-investment grade
Ba2 BB BB
Ba3 BB- BB-
B1 B+ B+ Fairly speculative
B2 B B
B3 B- B-
Caa1 CCC+ CCC
Caa2 CCC Higher risk of default
Caa3 CCC-
Ca CC CC
C C Lowest quality, highest risk
C  D D Default

Why Ratings Matter

A ratings system is an easy way to judge the financial strength of an issuer. This isn’t hard to find out for companies. 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 to your risk profile just by checking the rating.

You can do the same with bond funds too. Funds offer a lot of information on average credit quality and break down its bond holdings by ratings.

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. It’s an easy way to streamline the research process.

Of course, for this to be relevant, the ratings agencies must be right. This doesn’t mean you should ignore ratings entirely. Rather, use the bond ratings as a basic default risk guide and be aware of any rating changes.

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Comments

  1. says

    I’d love to hear your take on the bond rating firms’ performance leading up to the 2008 financial crisis. Weren’t some bonds rated very highly literally up until the point of default? Also, a related question: do you believe that, in general, the agencies’ ratings are not influenced by their business interests and other pressures from Wall Street players?

    • Jon says

      I know Lehman Brothers debt and MBS’s were both overrated. The ratings were changed after the default (for Lehman, after it went bankrupt). There were too big issues that led to the crisis: excessive debt, much of it to people that couldn’t cover it, and a bubble in housing prices. The credit agencies helped facilitate it with high ratings. To be fair, the agencies needed to recognize the bubble in housing before it popped in order to provide accurate ratings.

      As far as influence, the ratings process is imperfect. I’m sure business interests play some role. But companies, banks, governments etc, are required by the SEC to have debt rated before it’s issued. Moody’s and S&P control most of that market. When there’s a near duopoly for credit ratings, I’m not sure what incentive an agency has to provide a higher rating, unless they’re able to charge more for higher rated securities.

  2. says

    It seems like all the ratings companies were overly exuberant about the mortgage-backed securities that lots of investment banks were peddling back in 2006-2007. It makes you wonder how much you can trust these ratings agencies.

    • Jon says

      I’m not sure the agencies were fully capable of providing an accurate rating given the circumstances. Even before then I viewed bond ratings much like stock analysts grades. Most upgrades and downgrades happen after the fact.

  3. says

    I often take a common-sense approach when looking at bond ratings. I actually look at the particular issuing institution and ask myself, “are they going to default and if not, what could lead them to default?” it’s kind of picky but it helps me eliminate a lot of duds and emotional investing.

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