A:

Moody's, Standard and Poor's, Fitch Rating and Dominion Bond Rating Service are some of the internationally well-known bond rating agencies. These organizations operate to provide investors with quantitative and qualitative descriptions of the available fixed income securities. A "AAA" high grade bond offers more security and a lower profit potential (lower yield) than a B- speculative bond. While such metric provides a sense of the overall characteristics of the security, what sort of underlying analysis goes into differentiating between bond qualities?

For a financial institution, ratings are developed based on specific intrinsic and external influences. Internal factors include such traits as the overall financial strength rating of the bank – a risk measure illustrating the probability that the institution will require external monetary support (Moody's implements a scale where A corresponds with a financially healthy bank, and E resembles a weak one). The rating depends on the financial statements of the firm under analysis and the corresponding financial ratios. (To learn about financial ratios, check out Financial Ratio Tutorial.)

External influences include networks with other interested parties, such as a parent corporation, local government agencies and systemic federal support commitments. The credit quality of these parties must also be researched. Once these external factors are analyzed, a comprehensive overall external score is given. Essentially, this grade is added to the predetermined "intrinsic score" to obtain the overall grade like BBB.

The preceding guideline provides a general frame work that Moody's uses in its analysis. Specific bonds, such as hybrid securities, require additional complex analysis, such as the underlying terms of the debt.

Overall, the art of bond rating extends beyond simple ratio analysis and a quick look at a firm's balance sheet. Different measures are used for different industries, and different external influences play ranging roles in the intricate process. A forecasted top-down approach of the overall economic conditions, an in-depth bottom-up procedure of security specifics, along with statistical distribution estimates of the probability of default and loss severity provides investors with a few simple letters to quantify their investment. (Learn about bond investing, read Bond Portfolios Made Easy.)

This question was answered by Arthur Pinkasovitch

RELATED FAQS
  1. What are the highest-yielding investment grade bonds?

    Learn how Standard & Poor's and Moody's rate bonds. Understand what investment grade bonds offer the best yield. Read Answer >>
  2. Where can I find information about corporate bond issues?

    Learn information about corporate bond investments, including where investors can access information about new corporate ... Read Answer >>
  3. What causes a bond's price to rise?

    Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
  4. Which securities are considered investment grade?

    Learn which securities are considered investment grade by credit rating agencies such as Standard & Poors and Moody's and ... Read Answer >>
  5. How are junk bonds rated differently by Standard & Poor's and Moody's?

    Learn how credit rating agencies rate bonds with junk bond status, and understand how downgrade risk can impact the price ... Read Answer >>
  6. How safe are high yield bonds?

    Learn how high-yield bonds have a greater risk of default than investment grade bonds and why they offer higher amounts of ... Read Answer >>
Related Articles
  1. Investing

    Explaining Bond Ratings

    A bond rating is a grade given to a bond to indicate its creditworthiness.
  2. Investing

    What does Investment Grade Mean?

    Investment grade is a term used to describe a favorable rating for corporate and municipal bonds.
  3. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  4. Investing

    What's a High-Yield Bond?

    A high-yield bond is a bond issued by a company with a very low credit rating.
  5. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  6. Personal Finance

    A Brief History Of Credit Rating Agencies

    Credit rating agencies have a long history in this country. Learn about what they do and how were they developed.
  7. Financial Advisor

    Advising FAs: Explaining Bonds to a Client

    Most of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need ...
  8. Investing

    When To Trust Bond Rating Agencies

    Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point.
  9. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  10. Investing

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
RELATED TERMS
  1. Bond Rating

    A grade given to bonds that indicates their credit quality. Private ...
  2. Bond Rating Agencies

    Companies that assess the creditworthiness of both debt securities ...
  3. Moody's

    An independent, unaffiliated research company that rates fixed ...
  4. Credit Quality

    One of the principal criteria for judging the investment quality ...
  5. Moody's Bond Survey

    A weekly publication that reports changes in corporate bond quality ...
  6. AAA

    The highest possible rating assigned to the bonds of an issuer ...
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center