When an investor or institution buys bonds, they're lending the issuer money. Bond ratings were developed to help these creditors to understand the relative risk involved with the purchase of a bond. They enable the investor to evaluate, and balance, the risk of default with the interest rate, or yield, paid on the security.
Bonds and the Risk of Default
Buying bonds is oftentimes mistakenly thought to be a risk-free investment; the interest expense is paid before any dividends are provided to stockholders. In fact, unless a company is prepared to declare bankruptcy, the chance of non-payment is very small. Unfortunately, as small as that risk might be, there are companies that go into default; the risk is not only possible, it is also very real.
When that happens, the bondholder not only doesn't get paid their interest payment, but they're also at risk of losing the money they're owed on the bond. Keep in mind that some securities are issued with maturities of ten years or more. In this fast-paced economy, the financial health of many companies can change dramatically over ten years.
Quantifying Default with Ratings
Perhaps the most important value bond ratings provide investors is an independent assessment of the bond's risk. Ratings are a third party's assessment of the issuer's ability to make all of their future financial commitments to creditors.
As new information becomes available, this data can change a company's financial stability or earnings outlook. The credit rating of the company may change to reflect this new information.
Quality Ratings
When a company's bond ratings are in the news, they're reporting a change in the credit quality of the issuer. A company with a poor rating presents a credit risk to the bond market, banks, and investors, which lend companies money by purchasing their bonds. As a creditor of that same company, they're assuming a risk of repayment or nonpayment.
Credit Rating Agencies
Currently, there are three credit agencies that set standards for bond quality ratings: Moody's, Standard and Poor's, and Fitch Ratings. Each agency has a slightly different bond rating system. These small differences also work to the investor's advantage because all three agencies issue an alert when they are considering a change in a company's rating.
This means an investor has access to several independent sources of information when evaluating the risk of default. For Moody's, this alert system is termed Under Review. For S&P it's called CreditWatch, and Fitch simply calls it Rating Watch. These terms are used to alert investors to a possible, or pending, change in a company's bond rating.
Bond Rating Credit Codes
There are roughly ten different ratings, or grades, that each agency publishes. The ratings range from Investment Grade to In-Default. In addition, each company offers refinements, or additional granularity, to these codes such as a plus or minus sign to indicate direction or relative standing within a particular rating category. The following table shows the relative rating system for all three agencies:
Bond Rating Grades
Credit Risk | Moody's | Standard and Poor's | Fitch Ratings |
Investment Grade | |||
Highest Quality | Aaa | AAA | AAA |
High Quality | Aa | AA | AA |
Upper Medium | A | A | A |
Medium | Baa | BBB | BBB |
Not Investment Grade | |||
Lower Medium | Ba | BB | BB |
Lower Grade | B | B | B |
Poor Grade | Caa | CCC | CCC |
Speculative | Ca | CC | CC |
No Payments / Bankruptcy | C | D | C |
In Default | C | D | D |
Note: Moody's uses a modifier of 1, 2, or 3 to show relative standing in a category. Standard and Poor's and Fitch Ratings use a modifier of plus or minus.
Credit Rating Example
Listed below are several examples that illustrate how to read these ratings, and understand how the refinements work:
If a company is carrying a credit rating from Standard and Poor's of BBB-, then it is of lower quality than a company carrying a credit rating of BBB. A company with a credit rating of BBB+ is of higher quality than BBB.
A company carrying a credit rating from Standard and Poor's of BBB is of similar credit quality to a company carrying a credit rating of Baa from Moody's.
Bonds carrying a credit rating of Ba or BB and lower are not considered investment grade. Bonds with ratings of Baa or BBB and higher are considered investment grade.
Credit Ratings and Profits
The impact of credit ratings on a company's ability to raise capital can be enormous. While some changes might seem like subtle differences, to companies looking to borrow money on the market, each little movement adds to, or lowers, their cost of borrowing in terms of interest expense.
When a company's credit rating is lowered, the cost to borrow additional money increases, since new securities will require a higher interest rate. In turn, these higher expenses result in lower earnings per share, or a lowering of the company's overall profitability outlook.
Additional Resources
- Many investors easily make the transition from mutual funds to common stocks. That's a great start, because finding high quality bonds requires the same rigorous process as stocks.
Moneyzine EditorSeptember 20th, 2023 - There are two ways that individuals can invest in fixed-income securities: bond funds or individual bonds. The vast majority of securities are held by large institutions such as banks, pension plans, and insurance companies. Roughly 10% of all bonds are held directly by individuals.Moneyzine EditorSeptember 20th, 2023
- First authorized in 1997, Treasury-Inflation Protected Securities, or TIPS, are securities issued by the U.S. Treasury whose principal is linked to the Consumer Price Index. TIPS offer investors the opportunity to buy bonds, while at the same time protect themselves against inflation.Moneyzine EditorNovember 6th, 2024
- It's possible to compare bond yields to other investments using only four data points: par value, market price, maturity date, and the coupon rate. That's all the information needed to calculate the return from a bond. But as will be discussed later on, understanding the value derived from a bond is more complex than just calculating a yield to maturity.Moneyzine EditorNovember 6th, 2024
The price of high quality bonds is directly related to interest rates. Investors looking to expand the diversity of a portfolio of stocks need to understand the relationship between prices and interest rates before buying bonds.Moneyzine EditorNovember 6th, 2024
