What Are Bond Ratings?
A bond is a loan made from an investor to a corporation or a government entity. In return for their investment, the bondholder expects to be repaid their principal, or original investment amount, along with interest, which is known as the coupon. The longer the investment period or the riskier the company they are lending money to, the greater the amount of interest the bondholder will receive.
But how can investors tell how risky a bond is? All bonds receive a financial rating in the form of a letter grade. This illustrates their creditworthiness, telling investors how likely it is that a bond will be repaid by its issuer. That way, investors know how much risk they are assuming before they make their investment.
What Do Bond Ratings Agencies Do?
To help investors understand the creditworthiness of a bond, private rating agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings, conduct an assessment of the bond issuer at the time they issue a bond. They evaluate the issuer's ability and willingness to make all payments in full and on time. Each agency has its own grading system, but all use standard metrics and are considered reliable sources.
What Are the Bond Ratings?
Bond ratings agencies publish their ratings in an easy-to-understand grading system, which includes the grade and risk level:
|Bond Rating||Investment Grade|
Faces major uncertainties, although less vulnerable in the near-term
Faces major uncertainties has more near-term vulnerability to adverse business
Highly vulnerable to non-payment
Default has not yet occurred, although it is expected
Payment default, or in bankruptcy
The highest rating a bond can receive is AAA, and the lowest is D. An AAA rating means the issuer is extremely capable of meeting its financial commitments, while a D rating means the issuer is in the midst of bankruptcy or default and very likely won’t repay its loans.
U.S. Treasury securities carry the AAA rating and are considered the safest bonds because they are backed by the “full faith and credit” of the U.S. government, which is virtually guaranteed never to default.
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The AAA rating is rare in the corporate world. In the 1980s, there were dozens of corporations with AAA-rated bonds, but in order to grow profits, many assumed greater debt through buyouts and acquisitions, and their bond ratings fell.
Which Bond Ratings Are Investment Grade?
Bonds are divided into two categories:
- Investment-grade bonds are rated BBB or higher, which means they carry less risk of default. Credit ratings agencies have determined that they will more than likely meet their payment obligations. This has positive connotations for the borrowing costs of bond issuers because it means they will pay less interest on their debts. Because there is less risk involved, investment grade bonds usually offer lower yields than non-investment grade bonds.
- Speculative, or non-investment grade bonds, carry a rating of BB+ and lower. These are also known as high yield or junk bonds. These bonds offer investors higher yields to compensate for the increased risk they are taking. Companies usually issue junk bonds when they need to raise cash quickly. Junk bond yields soared as high as 14% in the 1980s, spurring loads of investment before quickly collapsing—and wiping out many investors.
How Are Bond Ratings Calculated?
Rating agencies analyze corporate financial statements in order to assess their credit quality. The metrics they use are proprietary, but some factors they might take into consideration in their statistical analysis include:
- Assets under management
- Likely return on investment
- Debt covenants
Do Bond Ratings Change Over Time?
Yes. Ratings are assigned when bonds are first issued and are reviewed on a regular basis. If a ratings agency concludes that an issuer's creditworthiness has improved, it may upgrade the bond. Conversely, if it concludes that an issuer's creditworthiness has deteriorated, it may downgrade.
UPS bonds, for example, were rated AAA back in the early 2000s, but after the company reached a long-term agreement with union workers, which increased wages and benefits but froze its pension obligations, credit ratings agencies downgraded the company to AA status.
In response to the downgrade, UPS raised its bond yields by about 0.5%, which investors did not seem to mind. In fact, these days, because so few companies earn the coveted AAA rating, downgrades are not considered as damaging to a corporate reputation as they once were.
Why Are Bond Ratings Important to Investors?
Bond ratings are an important way for investors to understand the risks they are taking when they invest in a bond. It alerts them to the quality of the bond—and why the bond may be offering a high yield. Bond ratings give investors an easy way to gauge how trustworthy of an investment a bond will be.
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