Bond Ratings 101

What are Bond Ratings and Why Do They Matter?

Bond Ratings 101
March 24, 2014

Bond ratings are a measure of the credit quality of a bond issuer. Bond assessment companies – known as “rating agencies” -- issue ratings that are data-driven opinions of relative creditworthiness, similar to personal credit assessment agencies that determine your credit score. The major rating agencies evaluate creditworthiness of both corporate and municipal bond issuers.

Just as your personal credit score sends a message to potential lenders about your perceived ability to repay, bond ratings send a message to potential investors about the issuer’s perceived ability to pay out interest or redeem the full value of the bonds at maturity.

Three major companies rate bonds – Standard and Poor’s, Moody’s and Fitch. They differ a bit but follow this general form:

  • “A” Ratings – AAA ratings are the highest grade, lowest risk bonds available, and are indicative of bonds with highly stable backings such as Treasury issues. AA and A ratings are still considered investment grade with solid fundamentals.

  • “B” Ratings – BBB ratings are arguably still within investment grade, depending on the level of risk that is tolerated. They are considered adequate but vulnerable to unfavorable changing conditions. Levels of vulnerability are even higher for medium-risk BB and B bonds.

  • “C” Ratings – CCC through C ratings are considered low quality and high risk. As you decrease in rating, the likelihood of some kind of non-payment is significant.

  • “D” Rating – Bonds that are in default for non-payment.

“A” and “B” grades have plus and minus sub-grades associated with them.

Higher rated bonds are considered extremely safe, and thus are desirable by investors seeking stable investments. Yields are correspondingly low, since investors are assuming little risk.

Conversely, bonds with low ratings must pay higher interest to attract investors – in turn increasing their payment burden. That leads to a greater impact of downgrading at lower scales. Dropping from AA to A+ grade is not quite as damaging as a drop from B to B- grade.

How do bond-rating companies evaluate bonds? They consider both the likelihood and severity of a loss.

They have significant staff devoted to in-depth analysis of the issuing entity, looking at factors such as cash flow, revenue projections, management changes, capital position, profitability (for corporate issuers), relative market position, and potential liability risks (including underfunded pension plans). The rating companies perform the analysis that individual investors and most groups do not have the time or expertise to handle.

Some have questioned the usefulness of the bond rating companies. They certainly took a credibility beating in the last banking crisis, and there is always potential for conflict of interest – since bond rating companies make money off the companies whose bonds they assess. In addition, with today’s information flow, many people have access to the same data as the bond analysts and can draw their own conclusion and react before the rating companies do.

Still, most investors don’t want to privately analyze bond issuer credit quality, and the rating agencies continue to be broadly respected. Any downgrading of a corporate or municipal issue can have plenty of ramifications aside from interest payments. For example, a downgrade can cause a company’s raw material suppliers to demand reduced payment cycles. Depending on their mandates, some institutional investors – such as pension funds or endowments -- may be barred from buying non-investment grade bonds.

What do you do if bonds you own are downgraded? It depends on if you think the issue is temporary or systemic. Do some research, and if it no longer fits in your risk tolerance or unbalances your portfolio, you can sell it. Just be prepared to accept a lower price due to the downgrade.

Remember, bond ratings are opinions. They are not recommendations to buy or sell; they are just one factor to use in assessing your portfolio options. With that in mind, they are useful tools for evaluating investments – ignore them at your own peril!

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