What is a Bond Rating
A bond rating is a grade given to bonds that indicates their credit quality. Private independent rating services such as Standard & Poor's, Moody's Investors Service and Fitch Ratings Inc. 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.
BREAKING DOWN Bond Rating
Most bonds carry a rating provided by one of the three independent rating agencies: Standard & Poor's, Moody’s and Fitch. From U.S. Treasuries to international corporations, these agencies conduct a thorough financial analysis of the entity that is issuing the bond. Based on each rating agency’s individually set criteria, analysts determine the entity’s ability to pay their bills and remain liquid and assign a credit rating to the bond.
Bond Ratings Affect Pricing, Yield, and a Reflection of Long-Term Outlook
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. A good example of non-investment grade bond can be seen with the S&P's stance on Southwestern Energy Company, which was given a rating of "BB+" bond rating and negative outlook.
Independent Rating Agencies Get Tripped Up In 2008 Downturn
Looking back to one of the worst recessions in recent times, many people believe that the independent bond rating agencies played a pivotal part in the 2008 downturn. As the investment world has learned in the years since the crisis, the rating agencies were being paid to provide higher bond ratings, thereby giving the bonds more worth, in exchange for illegal forms of payment. One prime example of their destructive policies during the 2008 recession can be determined by Moody's downgrade of 83% of $869 billion in mortgage-backed securities that were given a rating of "AAA" just the year before.
In short, long-term investors should carry the majority of their bond exposure in more reliable, income-producing bonds that carry investment grade bond ratings. Speculators and distressed investors making a living off high-risk, high-reward opportunities could turn to non-investment grade bonds for speculative opportunities.