Bond-rating scale: what is it, and how does it work?

Bond-rating helps investors assess a bond issuer’s financial strength to repay the debt on time. Bond-rating agencies set up rating scales to evaluate bond issuers’ creditworthiness. Understanding the credit ratings is essential to bond investors, whether institutional or individual investors, help in investment decisions.

This article will discuss what bond rating is; how bonds are rated; then, we will elaborate on the current leading 3 rating agencies and their rating systems. Finally, we also mention the implications of different bond ratings, outstanding bond ratings, and BBB ratings.

Essentials of bond ratings

What is a bond rating?

A bond rating is to evaluate a commercial corporation’s or a government agency’s creditworthiness. Contrary to an individual’s credit score, the rating agencies publish the institutions’ rating scores. Investors make investment decisions based on the financial strength and their probability of repaying the debt.

  • A bond rating process involves three major parties. 1.A bond issuer plans to raise the money. 2. A rating agency assesses the bond issuer’s default risk and cash flow risk. 3. Bond investors buy the bonds and loan the money.
  • There are two types of bond issuers: 1. Government agencies, e.g., local governments, central banks and treasury departments, etc. 2. Private Institutions, e.g., public-listed companies. They need additional capital for operating and cash flow needs. Enterprises need financing or refinancing for their projects.
  • Rating agencies: Three primary agencies occupy more than 95 percent of the credit rating market. They are Standard & Poor’s, Moody’s, and Fitch. They are all paid agencies to assess bond issuer’s credit quality.
  • Bond investors consist of 1. Institutional ones: they are bond funds, insurance companies, banks, sovereign wealth funds and corporations, and retirement funds, etc. They invest in bonds to maintain a regular and steady income for fund owners. 2.) Individual bond investors: they invest in bonds for personal wealth and income accumulation.

What factors affect bond ratings

Internal factors

  1. Creditworthiness: Like a credit bureau, a credit agency evaluates a corporation’s ability to pay back the debt. If an institution is not likely to pay back principals and interests on time, it may have a higher default risk like Finnie Mae and Freddie Mae during the financial crisis in 2008. A corporation may have difficulty in cash flow payments due to deteriorating business situations.
  2. Capital structure: A bond issuer may have complicated capital systems, and it can cause a company to repay even if it has healthy business growth. So a company can set up orders and priorities to pay back creditor’s loans. As a result, investors of lower priorities may have a higher default risk of principal or interest payments or both!
  3. A bond issuer’s competitiveness: If a corporation has edges in business competitions and the capability to increase profit among competitors, it can make bondholders more assured of its ability to pay back principal and interest.
  4. Financial health: A company’s financial position reflects its financial strength and commitment. Of these is a company’s balance sheets, which provide more financial information for investors.

External factors

  1. Microeconomic: Changes in industry and government regulations may have an impact on a company’s competitiveness. For example, more and more consumers are using more online shopping. As a consequence, online companies find bond issues easier than mall operating companies.
  2. Unpredictable events in the future: Unexpected events like earthquakes, pandemics, and floods cause unforeseen damages in principal and interest payments. It is beyond a corporation’s financial commitments.
  3. Third-party risks: Rating agencies consider third-party’s ability to guarantee bond issuer payments. The financially stronger the guarantor, the more secure the commitments become. 

How are bonds rated?

A bond rating is a grade assigned to a bond. The rating defines the borrowing corporation’s financial strength and willingness to repay the debt.

Generally, most bonds are rated by the three rating agencies: Standard & Poor’s, Moody’s & Fitch. They all have their rating systems in place. However, they have clear definitions for grading bonds. 

In terms of investment grades, bonds are all classified into three types:

  1. Investment-grade;
  2. Non-investment grade;
  3. Not-rated. 

According to the US Securities and Exchange Commission, investment-grade bonds have a lower risk of default and a higher likelihood of paying on time, so they have a higher rating. However, non-investment grade bonds, also called high-yield or speculative bonds, are the reverse, so they pay a higher interest. Not-rated bonds are bonds not rated by agencies; they are more likely to default than speculative bonds.

Besides, bond ratings range from the highest quality to the default class. The latter pays the highest rate of interest, with the former the least.

The three rating agencies

  • S&P Global Bond Ratings: it is one of three rating agencies recognized by the Securities and Commission and the oldest. It rates numerous government and corporate bonds and structured finance entities and securities. One of its main jobs is to assess a bond’s default risk. The following table lists the features of their grading system:
GradeDescriptionRating
InvestmentExtremely strong capacity to meet financial obligations.AAA
InvestmentVery strong capacity to meet financial obligations.AA
InvestmentStrong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.A
InvestmentAdequate capacity to meet financial commitments, but more subject to adverse economic conditions.BBB
SpeculativeLess vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.BB
SpeculativeMore vulnerable to adverse business, financial, and economic conditions but currently has the capacity to meet financial commitments.B
SpeculativeCurrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.CCC
SpeculativeHighly vulnerable; default has not yet occurred but is expected to be a virtual certainty.CC
SpeculativeCurrently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher-rated obligations.C
SpeculativePayment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed, or similar action is taken.D
N/AThe security was not rated.
  • Moody’s Investors Service Bond Ratings: It deals with evaluating projected loss in case of default. The rating services cover financial, non-financial institutions; sovereignty; structured financial transactions, infrastructure, and project financing.
GradeDescriptionRating
InvestmentObligations of the highest quality, with minimal risk.Aaa
InvestmentObligations of high quality, with very low credit risk.Aa(1,2,3)
InvestmentObligations of upper-medium-grade, with low credit risk.A(1,2,3)
InvestmentObligations of moderate credit risk that may possess speculative characteristics.Baa(1,2,3)
SpeculativeObligations with speculative elements that are subject to substantial credit risk.Ba(1,2,3)
SpeculativeObligations are considered speculative that are subject to high credit risk.B(1,2,3)
SpeculativeObligations of poor standing and are subject to very high credit risk.Caa(1,2,3)
SpeculativeHighly speculative obligations that are likely in, or very near, default, with some prospect of recovery in principal and interest.Ca
SpeculativeLowest-rate class of obligations that are typically in default, with little prospect of recovery of principal and interest.C
#the numbers in the bracket indicate the obligations to pay from 1-strongest, 2-stronger, 3-strong.
  • Fitch Ratings: It is the smallest of the three. Like S&P’s, it rates the probability of default. It also covers sovereigns, financial institutions, corporate finance, Islamic finance, structure finance, and global infrastructure.
GradeDescriptionRating
InvestmentExtremely strong capacity to meet financial obligations.AAA
InvestmentVery strong capacity to meet financial obligations.AA
InvestmentStrong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.A
InvestmentAdequate capacity to meet financial commitments, but more subject to adverse economic conditions.BBB
SpeculativeLess vulnerable in the near-term but faces significant ongoing uncertainties to adverse business, financial and economic conditions.BB
SpeculativeMore vulnerable to adverse business, financial, and economic conditions but currently has the capacity to meet financial commitments.B
SpeculativeCurrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.CCC
SpeculativeHighly vulnerable; default has not yet occurred but is expected to be a virtual certainty.CC
SpeculativeCurrently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher-rated obligations.C
SpeculativePayment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed, or similar action is taken.D
SpeculativeThe security was not rated.NR

Investment-grade vs. Junk Bonds

Bond-rating agencies assess bonds per bond quality and stability. Besides, the rating process involves expectations and outlook. These factors undoubtedly influence an investor’s attitude towards bond investment. 

Investment-grade bonds are rated quality-grade as they provide stable cash flows and are viewed as safe investments. However, the rates of interest are relatively low. They range from “AAA” with the most robust financial strength to “BBB” grading with the least.

Bond not belonging to the bonds as mentioned above are non-investment grades or “not-rated.” They are high-yield or junk bonds with attractive rates of interest. Investors interested in these bond investments should beware of bond issuers’ financial aspects and business circumstance changes.

Generally, junk bonds are divided into two major categories:

  • Fallen Angels: The bond issuer’s rating has lowered from “investment” grade to “non-investment or junk” status.
  • Rising Stars: The status of “non-investment” is promoted to “investment” or higher “non-investment” grades.

Conclusion

If you intend to invest in bonds, you should use a bond rating scale provided by a rating agency to assess your potential bond issuer and bond’s quality. More than that, you should look beyond the rate of interest as a bond’s viability is determined by multiple factors. 

An investor should note the implications of “investment” and “speculative” or not-rated graded bonds. The three rating agencies provide reliable information needed to assist investors in doing the jobs. 

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