Investors want to know the risks in buying a bond before they take the plunge.

Just as potential lenders turn to credit reporting agencies to check the risk they’d be taking in extending credit to you, potential bond investors turn to bond rating firms for a sense of the credit risk they would be assuming in buying particular debt security.

What is a Bond rating?

A bond rating is a grade assigned by a rating agency that measures the creditworthiness of a bond.

Independent rating services evaluate a bond issuer’s financial stability or its capacity to make timely principal and interest payments on bonds. Standard & Poor’s (S&P), Moody’s Investors Service, Inc., and Fitch Ratings are the best-known firms. These companies assess the creditworthiness of a bond issuer or an issue rather than the bond’s market appeal.

They look at other debt the issuer has, how fast the company’s revenues and profits are growing, the state of the economy, and how well other companies in the same business (or municipal governments in the same general shape) are doing. However, the firms’ reputations have suffered since 2008 due to the high ratings assigned to risky mortgage-backed securities (MBS).

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Bond ratings are expressed as letters ranging from “AAA,” the highest grade, to “D,” the lowest grade. While all rating services use the same letter grades, they differentiate themselves by using different combinations of upper- and lower-case letters and modifiers.

What is rated?

The rating services evaluate sovereign, municipal, corporate, and international bonds and structured products, as well as MBS. U.S. Treasury issues are not rated individually, though the U.S. government is rated. Since Treasury issues are obligations of the federal government, they are backed by its full faith and credit.
This means the government has the authority to raise taxes to pay off its debts.

What rating services don’t evaluate is market risk or the impact that changing interest rates and other factors will have on the market price of a bond you sell before maturity. Even the highest-rated bonds and U.S. government issues are vulnerable to loss of market value as interest rates rise.

Who uses bond ratings?

Individual investors use credit ratings to help make purchase decisions that are in line with their risk tolerance. In addition, they may want to check how much they could reasonably expect to recover if the issuer defaults. But before investing in any bonds, including rated bonds, investors should do their analysis or consult with their financial advisers.

Institutional investors, such as mutual fund companies, university endowments, and pension funds, typically use ratings with their credit analysis to evaluate the relative credit quality of specific issues.

Rating Bonds

In addition, some institutional investors operate under guidelines that require them to purchase issues of at least a minimum credit quality. Businesses and financial institutions often use credit ratings to evaluate how much risk they would take by entering into a financial agreement with another firm, described as a counterparty. In addition, issuers themselves use credit ratings to provide independent verification of their creditworthiness and the credit quality of their securities.

What influences Bond ratings?

The ratings generally correlate with elements like yield, the chance of a return on investment, rules governing the securities, and the company’s assets. In addition, major bond rating companies assess a company’s financial stability and standing to issue a bond rating. They also issue ratings based on future expectations and outlooks.

A company’s credit risk is one of the main elements influencing bond rating. The ability of the business to repay its debts to creditors is the main factor considered when assessing credit risk. These obligations include insurance payments, dividends, and loan principal and interest payments.

Bonds with the highest ratings often have a lower yield. This is because creditworthiness and yield have an inverse relationship. In bonds with the same maturity, typically, the higher the bond’s rating, the lower its interest and yield. Minor upgrades and downgrades tend to result in relatively small adjustments to yield. But if a bond’s credit rating is moved up to investment grade or down to junk, there may be a significant change in demand and, therefore, in yield.

Bond rating agencies frequently review a company’s bond rating when a significant corporate event, whether positive or negative, takes place.

Investment grade generally refers to any bonds rated BBB or higher by Standard & Poor’s and Fitch.

The comparable Moody’s ratings are Baa and higher.

What are investment grade and junk Bonds?

Investment-Grade Bonds are considered worthy of investment with a reasonable level of risk and low likelihood of default. Bonds with higher ratings, or investment-grade bonds, are considered safer and more reliable investments because they are linked to businesses or governmental bodies with promising futures.

Investment-grade bonds have ratings ranging from “AAA” to “BBB” (or Aaa to Baa3 on Moody’s rating scale), and bond yields typically rise as rating drop. Most of the “AAA” bond securities that are most popular are U.S. Treasury Bonds. Junk bonds are the lowest-rated corporate and municipal bonds with a greater-than-average risk of default. But investors may be willing to take the risk of buying these low-rated bonds because the yields are much higher than on other, higher-rated bonds. However, the prices are also volatile, exposing investors to increased market risk. Bonds classified as “junk” or even below investment grade typically have ratings ranging from “BB+” to “D” (Baa1 to C for Moody’s) and sometimes even “not rated.”

Why is Bond rating important?

The bond rating process is crucial because it informs investors of the bond’s quality and stability. As a result, these ratings greatly influence interest rates, investment appetite, and bond pricing. Bond ratings are given to companies that issue bonds and the bonds themselves. The higher a bond’s letter rating, the lower the interest rate coupon must be because the issuer is less likely to default. In contrast, the lower the bond rating, the more interest an issuer must pay to entice investors to buy. A good rating from the bond ratings agencies allows organizations to borrow money more cheaply.

Ratings can encourage businesses to pay their debts on time and refrain from taking on more debt than they can comfortably handle. One danger bondholders face is deteriorating the bond issuer’s financial condition. When that happens, a rating service may downgrade, sometimes substantially, its rating of the issuer based on how serious that financial difficulty is. If the downgrade is from investment grade to speculative grade, the issuer is sometimes known as a fallen angel.
It is important to check a bond’s rating regularly. Any downgrades or upgrades in the bond’s rating may impact the price buyers are willing to pay if the bond is sold before it matures.

Understanding Importance Of Bond Rating by Inna Rosputnia

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