How Are Bonds Rated?

A bond rating is a grade given to a bond by a rating service that indicates its credit quality. The rating 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 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.

Investment Grade vs. Junk Bonds

The bond rating is an important process because the rating alerts investors to the quality and stability of the bond. That is, the rating greatly influences interest rates, investment appetite, and bond pricing. Furthermore, the independent rating agencies issue ratings based on future expectations and outlook.

Higher rated bonds, known as investment-grade bonds, are seen as safer and more stable investments that are tied to corporations or government entities that have a positive outlook. Investment-grade bonds contain “AAA” to “BBB-“ (or Aaa to Baa3 for Moody’s rating scale) ratings and will usually see bond yields increase as ratings decrease. Most of the most common "AAA" bond securities are in U.S. Treasury Bonds.

Non-investment grade bonds or “junk bonds” usually carry ratings of “BB+” to “D” (Baa1 to C for Moody’s) and even “not rated.” Bonds that carry these ratings are seen as higher risk investments that are able to attract investor attention through their high yields. However, investors of junk bonds should note the implications and risks that are involved with investing in bonds that are issued by companies with liquidity issues. Junk bonds can be broken down into two other categories:

• Fallen Angels – This is a bond that was once investment grade but has since been reduced to junk-bond status because of the issuing company's poor credit quality.
• Rising Stars – The opposite of a fallen angel, this is a bond with a rating that has been increased because of the issuing company's improving credit quality. A rising star may still be a junk bond, but it's on its way to being investment quality.