A bond rating is a benchmark to gauge the creditworthiness of a bond, reflecting the cost of borrowing for the issuer. These ratings typically assign a letter grade to bonds to indicate 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 timely.
Key Considerations
- A bond rating is a letter-based credit scoring mechanism used to gauge the quality and creditworthiness of a bond.
- Investment grade bonds receive “AAA” to “BBB-” ratings from Standard & Poor’s and Fitch, and “Aaa” to “Baa3” from Moody’s. Bonds rated lower are considered junk bonds.
- Bonds with higher ratings have lower interest rates due to reduced risk, everything else being equal.
- Rating agencies assess bonds across various categories, including corporate and sovereign bonds.
Understanding Bond Ratings
Many bonds carry ratings from at least one of the following key independent rating agencies:
- Standard & Poor’s
- Moody’s Investors Service
- Fitch Ratings Inc.
To determine a bond’s rating, these agencies perform a detailed financial analysis of the bond’s issuer, covering both U.S. Treasuries and international corporate bonds. Analysts review the issuer’s capacity to pay its bills and maintain liquidity while also taking into account future expectations and outlook. Combining these data points, agencies assign a bond’s overall rating.
Pricing, Yield, and a Reflection of Long-Term Outlook
Bond ratings significantly inform investors about the bond’s quality and stability, greatly influencing interest rates, investment demand, and bond pricing.
Higher-rated bonds, known as investment-grade bonds, are deemed safer and more stable investments, often associated with publicly traded corporations and government entities with positive outlooks.
Investment-grade bonds boast “AAA” to “BBB-” ratings from Standard & Poor’s and Fitch, and “Aaa” to “Baa3” from Moody’s. Typically, bond yields increase as ratings decrease. U.S. Treasury bonds are a common example of AAA-rated bond securities.
Non-investment grade bonds, or junk bonds, usually have ratings from “BB+” to “D” for Standard & Poor’s and Fitch, and “Baa1” to “C” for Moody’s. In some cases, such bonds receive a “not rated” status. Despite the higher risks, junk bonds often attract investors due to their higher yields. However, they can face liquidity issues and might default, resulting in significant losses for investors.
Impact of Rating Agencies on the 2008 Financial Crisis
Independent bond rating agencies are believed by many to have played a significant role in contributing to the 2008 financial crisis. Prior to the crisis, some agencies were reportedly bribed for artificially high bond ratings, leading to inflated valuations. For instance, Moody’s downgraded 83% of $869 billion in mortgage-backed securities, which had retained an “AAA” rating a year prior.
In summary, long-term investors should primarily hold investment-grade bonds to ensure reliability and steady income, whereas speculators seeking high-reward opportunities might consider venturing into non-investment grade bonds.
Why Do Bonds With Lower Ratings Have Higher Yields?
Bonds with lower ratings come with a higher risk of default, leading to higher yields to attract investors despite the increased risk.
Understanding Junk Bonds
Non-investment grade bonds, or junk bonds, are high-yield, high-risk bonds typically rated from “BB+” to “D” or not rated. While investors can profit from junk bonds, they remain at a higher risk of losing their investment due to potential liquidity issues these companies face.
What Makes a Bond Investment Grade?
An investment-grade bond is considered a high-quality, low-risk bond with a minimal default rate. Bonds rated “AAA,” “AA,” “A,” and “BBB” fall under the investment grade category.
The Bottom Line
Bond ratings, assigned by credit rating agencies like Moody’s, Standard & Poor’s, and Fitch Ratings, provide a measure of the bond’s creditworthiness. Ratings indicate the bond issuer’s financial strength and capacity to pay the bond’s principal and interest. Higher-risk bonds feature higher yields, while lower-risk bonds offer lower yields.
Related Terms: creditworthiness, bond yields, investment risk, financial strength, credit rating agencies.
References
- Fidelity. “Bond Ratings”.
- Fitch Ratings. “Fitch Downgrades the United States’ Long-Term Ratings to ‘AA+’ from ‘AAA’; Outlook Stable”.’
- The Council on Foreign Relations. “The Credit Rating Controversy”.
