A bond rating is a grade given to a bond by various rating services that indicates its credit quality. It takes into consideration a bond issuer's financial strength or its ability to pay a bond's principal and interest in a timely fashion.

Moody's, Standard and Poor's, Fitch Ratings and DBRS are some of the most internationally well-known bond-rating agencies. These organizations operate to provide investors with quantitative and qualitative descriptions of the available fixed income securities. Generally, a "AAA" high-grade rated bond offers more security and a lower profit potential (lower yield) than a "B-" rated speculative bond.

While this metric provides a sense of the overall characteristics of the security, what sort of underlying analysis goes into differentiating between bond qualities?

Determining Ratings for Bonds

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.

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 framework 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 other external influences play a range of 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 standardized letters to help quantify their investment.

(Learn about bond investing, read Bond Portfolios Made Easy.)