Complete Guide To Corporate Finance

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Bonds - Bond Ratings

A bond rating is a grade given to a bond that indicates its credit quality. Private independent rating services provide these evaluations of a bond issuer's financial strength or its ability to pay a bond's principal and interest in a timely fashion. Bond ratings are expressed as letters ranging from "AAA," which is the highest grade, to "C" or "D" ("junk"), which is the lowest grade. Different rating services use the same letter grades, but use various combinations of upper and lower-case letters to differentiate themselves.

The bond rating system helps investors determine a company's credit risk. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the United States: Moody's, Standard and Poor's and Fitch Ratings.


Bond Rating
Grade
Risk
Moody\'s
S&P/ Fitch
Aaa
AAA
Investment
Highest Quality
Aa
AA
Investment
High Quality
A
A
Investment
Strong
Baa
BBB
Investment
Medium Grade
Ba, B
BB, B
Junk
Speculative
Caa/Ca/C
CCC/CC/C
Junk
Highly Speculative
C
D
Junk
In Default


Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because these bonds are so risky, they have to offer much higher yields than any other debt. Bonds are not inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.


Rating the creditworthiness of a bond issuer, despite the number crunching, is as much an art form as it is a science. While companies like Moody's and A.M. Best gather and analyze mountains of data, the rating itself comes down to the informed opinion of an analyst or a rating committee.

The organizations that rate bonds look at an issuer's assets, debts, income, expenses and financial history. In addition, they give special attention to the trustworthiness of a company to repay previous bond issues on time and in full.

Rating agencies regularly review bond ratings every six to 12 months. However, a bond may be reviewed at any time the agency deems necessary for reasons including missed or delayed payments to investors, issuance of new bonds, changes to an issuer's underlying financial fundamentals, or other broad economic developments. (For more on this subject, read The Debt Ratings Debate.)


Institutional and individual investors rely on bond rating agencies and their in-depth research to make investment decisions. Rating agencies play an integral role in the investment process and can make or break a company's success in both the primary and secondary bond markets. While the rating agencies provide a robust service and are worth the fees they earn, the value of such ratings has been widely questioned since the 2008 financial crisis, and the agencies' timing and opinions have been criticized when dramatic downgrades have come very quickly.

Investors should not rely solely on the bond rating agency's rating and should supplement the ratings with their own research. It's also important to frequently review the ratings over the life of a bond. (Read more in Bond Rating Agencies: Can You Trust Them? and Why Bad Bonds Get Good Ratings.)

Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm's repayment ability. Because the rating systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are considering.

The Bond Market
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