How Are Bonds Rated?

A bond rating indicates its credit quality and is assigned to a bond by a rating service. The rating takes into account a bond issuer's financial strength, or its ability to pay principal and interest on a bond. Moody's, Standard and Poor's and Fitch Ratings are well-known bond rating agencies.

These organizations provide investors with quantitative and qualitative descriptions of available fixed income securities. Generally, an investment-grade “AAA” bond offers more safety and a lower yield than a “B-” rated junk bond.

Key takeaways

  • Credit ratings assigned by rating services guarantee the quality and risk of a bond.
  • Rating agencies use several measures to determine their rating for a particular issuer's bonds.
  • A company's balance sheet, earnings outlook, competition and macroeconomic factors determine a credit rating.

Bond rating

Ratings are based on specific intrinsic and external influences. Internal factors include the overall financial strength rating of the financial institution. Moody's applies a scale in which A corresponds to a financially healthy bank and E to a weak institution. The rating depends on the company's financial statements and corresponding financial ratios.

External influences include interested parties, such as a parent company, local government agencies, and systemic commitments of federal support. The credit quality of these parties is reviewed and an overall overall external rating is assigned. This score is added to the predetermined “intrinsic score” to obtain the overall score.

Specific bonds, such as hybrid securities, take into account the underlying terms of the debt. Bond rating goes beyond simply analyzing a company's ratios and balance sheet. Different metrics are used for different industries, and external influences play a role in this complex process. A forecast of economic conditions, statistical distribution estimates of default probability and loss severity provide investors with standardized letters to help them quantify their investment.

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Investment grade bonds

The bond rating alerts investors to the quality and stability of the bond. Rating influences interest rates, investment appetite and bond prices. Additionally, independent rating agencies issue ratings based on future expectations and prospects.

Higher rated bonds, investment grade bonds, are safer, more stable investments tied to corporations or government entities. Investment grade bonds are rated from “AAA” to “BBB-”. Bond yields rise as ratings fall. The most common “AAA” bond securities are historically found in U.S. Treasury bonds.

In August 2023, Fitch Ratings lowered the long-term rating of the United States from 'AA+' to 'AA+' due to expected fiscal deterioration over the next three years, a high and growing public debt burden and the erosion of governance. compared to its “AA” and “AAA” peers over the past two decades, with repeated debt ceiling impasses and untimely resolutions.

Junk Bonds

Non-investment grade bonds or “junk bonds” are generally rated from “BB+” to “D” or “unrated”. Bonds with these ratings are considered higher-risk investments that can attract investors' attention with their high yields. Junk bond investors should be aware of the risks of investing in bonds issued by companies with liquidity problems.

  • Fallen Angel: This was an investment grade bond, but has since been reduced to junk bond status due to the poor credit quality of the issuer.
  • Rising star: Unlike a fallen angel, this is a bond whose rating has been upgraded due to the improvement in the credit quality of the issuer. A Rising Star may still be a junk bond, but it's on its way to becoming a quality investment.

Is a bond rating similar to an investor's credit report?

Like an individual's credit report and rating issued by credit reporting agencies, bond issuers are evaluated by rating agencies to assess their creditworthiness.

How do individuals invest in bonds?

Investors can purchase individual bonds or invest in a bond fund through a financial entity or institution such as Vanguard or Fidelity.

Why do lower rated bonds have a higher yield?

Lower-rated bonds generally offer higher yields to compensate investors for the additional risk.

The essential

Credit ratings, assigned by rating services such as Moody's, Standard and Poor's, and Fitch Ratings, are important indicators of a bond's quality and risk. Rating agencies take into account a bond issuer's financial health and its ability to pay a bond's principal with interest. Rating agencies give investors ratings, such as “AAA” or “B-,” which indicate whether a bond offers more safety and a lower yield or is more speculative.

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