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How Are Bonds Rated?

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A bond rating indicates its credit quality and is given to a bond by a rating service. The rating considers a bond issuer’s financial strength or ability to pay a bond’s principal and interest. Moody’s, Standard and Poor’s, and Fitch Ratings are well-known bond-rating agencies.

These organizations 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 yield than a “B-” rated speculative bond.

Key Takeaways

  • Credit ratings assigned by rating services provide a bond’s quality and riskiness.
  • Rating agencies use several metrics in determining their rating score for a particular issuer’s bonds.
  • A firm’s balance sheet, profit outlook, competition, and macroeconomic factors determine a credit rating.

Rating Bonds

Ratings are based on specific intrinsic and external influences. Internal factors include the overall financial strength rating of the financial institution. Moody’s implements a scale where A corresponds with a financially healthy bank, and E resembles a weak institution. The rating depends on the firm’s financial statements and corresponding financial ratios.

External influences include interested parties, such as a parent corporation, local government agencies, and systemic federal support commitments. The credit quality of these parties is researched, and a comprehensive overall external score is assigned. This grade is added to the predetermined “intrinsic score” to obtain the overall grade.

Specific bonds, such as hybrid securities, consider the underlying terms of the debt. Bond rating extends beyond simple ratio analysis and a firm’s balance sheet. Different measures are used for varying industries, and external influences play a role in the intricate process. A forecast of economic conditions, statistical distribution estimates of the probability of default, and loss severity provide investors with standardized letters to help quantify their investment.

Image by Sabrina Jiang © Investopedia 2020

Investment Grade Bonds

The bond rating alerts investors to the quality and stability of the bond. The rating influences interest rates, investment appetite, and bond pricing. Furthermore, independent rating agencies issue ratings based on future expectations and outlooks.

Higher-rated bonds, investment-grade bonds, are safer and more stable investments tied to corporations or government entities. Investment-grade bonds contain “AAA” to “BBB-“ ratings. Bond yields increase as ratings decrease. Most common “AAA” bond securities have been historically found in U.S. Treasury Bonds.

In August 2023, Fitch Ratings downgraded the long-term ratings of the United States to “AA+” from “AAA” based on the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to “AA” and “AAA” peers over the last two decades with repeated debt limit standoffs and untimely resolutions.

Junk Bonds

Non-investment grade bonds or “junk bonds” usually carry ratings of “BB+” to “D” or “not rated.” Bonds with these ratings are seen as higher-risk investments that can attract investor attention through their high yields. Investors of junk bonds should know the risks of investing in bonds issued by companies with liquidity issues.

  • Fallen Angel: This was an investment-grade bond but has since been reduced to junk-bond status because of the issuer’s poor credit quality.
  • Rising Star: The opposite of a fallen angel, this is a bond with a rating that has been increased because of the issuer’s improving credit quality. A rising star may still be a junk bond but is on its way to investment quality.

Is a Bond Rating Similar to an Investor’s Credit Report?

Similar to an individual’s credit report and rating issued by credit bureaus, bond issuers are evaluated by rating agencies to assess their creditworthiness.

How Do Individuals Invest in Bonds?

Investors can purchase individual bonds or invest in a bond fund through a financial entity or institution such as Vanguard or Fidelity.

Why Do Lower Rated Bonds Have a Higher Yield?

Lower-rated bonds generally offer higher yields to compensate investors for the additional risk.

The Bottom Line

Credit ratings, assigned by rating services such as Moody’s, Standard and Poor’s, and Fitch Ratings, are important metrics of a bond’s quality and riskiness. Rating agencies consider a bond issuer’s financial health and ability to pay a bond’s principal with interest. The rating organizations provide investors with grades, such as “AAA” or “B-” that indicate whether a bond offers more security and lower yield or is more speculative.

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