Investors want to know the risks in buying a bond before they take the plunge.
Just as potential lenders turn to credit reporting agencies as a way 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’d be assuming in buying particular debt security.
The best-known firms are Standard & Poor’s (S&P), Moody’s Investors Service, Inc., and Fitch Ratings. 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, in the wake of the high ratings assigned to risky mortgage-backed securities (MBS).
What is rated?
The rating services evaluate sovereign, municipal, corporate, and international bonds, and structured products, as well as MBS. US Treasury issues are not rated on an individual basis, though the US 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 that you sell before maturity. Even the highest-rated bonds and US government issues are vulnerable to loss of market value as interest rates rise.
Who uses 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 defaulted. But before investing in any bonds, including rated bonds, investors should do their own analysis or consult with their financial advisers.
Institutional investors, such as mutual fund companies, university endowments, and pension funds, typically use ratings in conjunction with their own credit analysis to evaluate the relative credit quality of specific issues. 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 be taking 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.
The SEC’s Office of Credit Ratings (OCR) was created by the Dodd-Frank Act to enhance investor protection by improving the quality of ratings and increasing the accountability, transparency, and competitiveness of the credit rating industry. It oversees the credit rating firms that have registered as nationally recognized statistical rating organizations (NRSROs), including S&P, Moody’s, and Fitch Ratings, and a number of other firms.
The OCR focuses on potential conflicts of interest in assigning ratings, compliance with securities laws and SEC rules, and adherence to internal methodologies the NRSROs have been required to develop.
In addition, the SEC has taken steps to limit reliance on NRSRO ratings as assurance of creditworthiness. For example, rules finalized since 2011 eliminate, among other provisions, the requirements that:
- Money market funds use the ratings to establish that a company is an eligible investment
- Broker-dealers include ratings in capital calculations and transaction confirmations
The risk of downgrading
One danger bondholders face is a deterioration of 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.
If downgrading occurs, implying increased credit risk, investors usually demand a higher yield for the existing bonds to compensate for that higher risk. Then the price of the bond falls in the secondary market. It also means that if the issuer wants to float new bonds, it may have to offer them at a higher interest rate to attract buyers.
Junk bonds are the lowest-rated corporate and municipal bonds that have 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 volatile as well, exposing investors to increased market risk.
Ratings may influence rates
Credit ratings can sometimes impact the interest rate an issuer must pay to attract investors. 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 big change in demand and therefore in yield.
When bonds have the same credit risk but different terms, those with longer terms typically pay higher rates. Offsetting the promise of higher yield is the potential for increased inflation, interest rates, and credit risks.
Understanding Importance Of Bond Rating by Inna Rosputnia
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