How are bonds rated?

By Arthur Pinkasovitch AAA
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. Does my debt-to-income (DTI) ratio affect my credit score?

    Though closely related, your debt-to-income ratio doesn't affect your credit score as directly as you might think.
  2. What counts as "debts" and "income" when calculating my debt-to-income (DTI) ratio?

    It's important to know your debt-to-income ratio because it's the figure lenders use to measure your ability to repay the ...
  3. Will getting a student loan deferral hurt my credit score?

    You may not be able to afford to pay your student loans, but the long-term consequence to your credit score be disastrous.
  4. How does bouncing a check affect my credit score?

    Learn the many indirect effects on your credit score when you bounce a check.
RELATED TERMS
  1. Impact investing

  2. Promotional CD rate (Bonus CD rate)

    A limited-time offer of a higher rate of return on a certificate ...
  3. Direct Bidder

    An entity that purchases Treasury securities at auction for a ...
  4. Indirect Bidder

    An entity that purchases Treasury securities at auction through ...
  5. Bid Wanted

    An announcement by an investor who holds a security that he or ...
  6. Insurance Company Credit Rating

    The opinion of an independent agency regarding the financial ...
comments powered by Disqus
Related Articles
  1. Emerging Market Bond ETFs: Look Under ...
    Mutual Funds & ETFs

    Emerging Market Bond ETFs: Look Under ...

  2. The Better Inflation Hedge: Gold or ...
    Investing News

    The Better Inflation Hedge: Gold or ...

  3. Find Security In Covered Bonds
    Insurance

    Find Security In Covered Bonds

  4. As Boomers Slow Down, Will The Economy ...
    Investing News

    As Boomers Slow Down, Will The Economy ...

  5. Invest In Emerging Market Bonds With ...
    Bonds & Fixed Income

    Invest In Emerging Market Bonds With ...

Trading Center