What Are Bond Ratings?
Agencies like Standard & Poor's (S&P) Global Ratings and Moody's Investors Services assign ratings to corporations and governments that issue debt, such as bonds, through a letter-based scale, similar to how credit rating agencies score individuals.
A bond's rating is the key indicator of the bond issuer's creditworthiness and the degree of risk to the investor that the issuer could default on the debt. AA+ and Aa1 are assigned by and Moody's, respectively, denoting high-quality investment-grade products. These scores signify the issuer is financially sound, has adequate revenues and cash reserves to pay its debts, and the risk of default is low.
Key Takeaways
- Standard & Poor's Global Ratings and Moody's Investors Services assign ratings to corporations and governments that issue debt using a letter-based scale.
- S&P rates long-term debt on a scale from AAA to D, where AA+ is a grade with a strong chance of repayment.
- Moody's scoring system ranges from Aaa to C.
- Bond ratings are similar to a consumer's credit rating.
AA+
S&P ratings are issued to long-term issuers of credit and insurance companies on a letter-based scale. The first rating is AAA, while the second highest is AA. Anything that falls in the A class is considered high quality, and the debt issuer has a strong likelihood of meeting its financial obligations.
According to S&P Global Ratings, a corporation with an AA rating has a "very strong capacity to meet its financial commitments." It deviates just slightly from the highest-rated companies.
S&P may add a "+" or a "-" to letter grades to "show relative standing within the rating categories." This means that an AA+ rating is slightly higher than an AA grade. S&P uses a different scale for long- and short-term debt. Short-term bonds considered investment quality are rated A-1, A-2, or A-3. B- or C-rated short-term bonds are deemed speculative or worse.
In 2023, Fitch Ratings joined S&P by downgrading the United States' credit rating from AAA to AA+, citing "repeated debt limit standoffs." The downgrade means that the country will pay slightly higher interest rates to compensate lenders for the increased level of risk.
Aa1
Moody's system is similar to that used by S&P. Debt issuers with the highest grades fall into the A-range beginning with Aaa. Aa is the next category, followed by A-grade investments. According to Moody's, an Aa-grade investment is "judged to be of high quality and are subject to very low credit risk." Investments with an Aa1 score indicate a "superior ability to repay short-term debt obligations
Moody's assigns numerical modifiers to these letter-based ratings. Adding a 1 puts it into the highest position of that range, while a 2 indicates a mid-range and a 3 denotes a low-range ranking.An Aa1 rating is higher than an Aa2 rating. It is also the second-highest score that Moody's can assign to investments and corporations after the Aaa rating.
The third of the Big Three credit rating agencies is Fitch, alongside S&P and Moody's.
Below AA+ and Aa1
For S&P:
- BBB: This rating signifies debts are fairly sound. If economic conditions or other circ*mstances change, the debt issuer may have trouble fulfilling its financial obligations.
- BB: These debts are more vulnerable to nonpayment because of problems within the business, the financial landscape, or the economy.
- B: S&P assigns this rating to debt issues significantly more vulnerable than a BB rating.
- CCC: If the debt issuer has any problems stemming from business, economic, or financial issues, it won't be able to repay its obligations.
- CC: Anything rated with a CC grade has a greater risk of default.
- C: Those with this rating are less likely to be repaid.
- D: A D rating is given to any company or debt issue in default or breach.
For Moody's:
- Baa: These ratings denote a moderate level of credit risk. Although speculative, they are commonly referred to as medium-grade investments.
- Ba: The credit risk with these speculative vehicles is significantly higher.
- B: Moody's assigns this rating to debt issues with high credit risk and are deemed speculative.
- Caa: Along with high credit risk, this rating is assigned to obligations considered to be highly speculative.
- Ca: These issues are likely to default. They may have a chance of recovery, though.
- C: This grade is assigned to low-class bonds that are in default. As such, there's very little chance that creditors will be repaid.
How Bond Ratings Are Used
Bond ratings are the equivalent of a consumer's credit rating for companies and governments that want to borrow money. The rating that a company's bond receives determines the rate of return (RoR) it will pay on its bonds. Each successive step lower in the ratings listed above means a step up in the rate of return and the degree of risk.
High-quality bonds have lower rates of interest. They are seen as safe-haven investments and are often bought by retirees seeking a steady income stream and investors seeking to balance riskier investments like stocks with high-quality, low-risk bonds.
Low-quality bonds are often referred to as high-yield bonds. They pay better because they have a greater risk that the issuer will default on their bond payments. The bond ratings call them non-investment-grade bonds. They're often referred to as junk bonds.
How Are Corporations and Governments Evaluated When Determining Bond Rating?
S&P and Moody's assign ratings based on inherent characteristics of a debt issue and the issuing company or of a particular country, along with other external factors. These include financial strength, which can be determined by analyzing financial statements and the financial ratios that are associated with them.
When Is a Bond Considered Speculative?
A bond is considered "speculative" if it has a rating below Baa3/BBB-. These ratings indicate a relatively high level of credit risk due to a high debt burden, low cash flows, or other uncertainties that may make it difficult for the borrower to make their payments on time. These instruments are sometimes called "high-yield bonds" or "junk bonds."
What Happens When a Credit Rating Is Downgraded?
A credit rating agency will downgrade the credit rating of a company or entity if they believe that the borrower will have trouble making their bond payments on time. When a credit rating falls, the borrower must pay higher interest rates to make up for the perception of increased risk.
The Bottom Line
AA+ and Aa1 are bond ratings associated with a relatively low-risk, low-yield investment as defined by the rating agency. An Aa1 rating is used by Moody's, and an AA+ rating is used by Fitch Ratings and Standard and Poor's. Both ratings indicate the second-highest level of creditworthiness.
