What is Bond Ratings
When any lending institution makes a loan to a consumer for an expensive purchase like a house or a car, the institution evaluates the borrower’s credit. Since the goal is for the institution to be paid back in full with interest, the institution tries to make sure that the borrower is currently financially able to meet the payment schedule and that the borrower has a track record for paying back loans on time. In other words, the bank or other institution evaluates the credit risk of any loan made to that borrower. Credit risk is a measure of the likelihood the borrower will default on the loan, causing the lending institution to lose money.
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The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and MoreBond ratings are a gauge of the credit risk you take as a bond purchaser. When you buy bonds, you are essentially making a loan to the issuer of the bonds. As an investor in bonds, your goal is to get your money back with interest. If the government, municipality, or corporation that issued your bond becomes insolvent and cannot pay what it owes to its creditors, you stand a chance of losing all or part of your investment. Thus it’s important that you have a means of determining the credit risk associated with a particular bond issue before you buy.
Fortunately, as an investor you don’t have to dig deeply into the financial records of organizations issuing bonds to assess their credit risk. Just as there are companies that provide banks and mortgage companies with credit reports on individual consumers, there are companies that specialize in doing the research required to provide credit reports on bond issuers. These companies investigate the financial condition of the issuers, their management practices, and their strategic plans in light of current economic and political conditions. A bond rating represents the sum of their findings.
The three major companies that rate bonds are Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. Bonds are rated when they are first issued and when the circumstances of the issuing organization change significantly. The conclusions of the three ratings companies are often the same, but not always. Moody’s, S&P, and Fitch have slightly different ways of notating their ratings. All of them rate bonds on a scale from highest to lowest quality. In general a high quality bond is one that has a low likelihood of default, but pays less interest than a low quality bond. As an investor you get rewarded for accepting more risk if things go well.
The rating scales listed here are ordered from the highest to the lowest degree of safety. The greatest credit risk is associated with the lowest rating. For example, an AAA or Aaa rating indicates the safest possible investment grade bond with almost no chance of default. A rating of B or B2 indicates a very speculative choice. When you get down to C and D ratings you are looking at issuers already in default or looking like they’re headed that way.
Moody’s: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C
Standard & Poor’s: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, D
Fitch: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC, DDD, DD, D
Bonds with BBB/Baa and above ratings are usually considered “investment grade.” Bonds with ratings of BB/Ba and below are considered “below investment grade” or “speculative” bonds. These lower-ranked bonds are also called “junk” bonds, reflecting their high credit risk, or “high-yield” bonds, reflecting their potential returns.
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