Bond Ratings: Explained | The Motley Fool (2024)

A bond's rating can tell you a lot about a particular security by using only a few letters or symbols. Here, we'll dive into what bond ratings are, the three chief agencies responsible for coming up with bond ratings, how a bond's rating is determined, and a brief primer on the difference between investment-grade and junk bond securities.

Bond rating agencies

Standard & Poor's, Moody's, and Fitch Ratings are the major bond rating agencies. Although their rating systems are slightly different in terms of the numbers and symbols used, a triple-A rating is widely considered the gold standard when it comes to bond quality. All three agencies strive to provide independent and unbiased reviews of a company's health and solvency, providing the potential buyer with useful information.

The major rating agencies are responsible for evaluating a bond issuer's credit quality. In other words, the agencies provide ratings to give investors some assurance that money invested in a particular security will be paid back. Rating agencies provide valuable information to investors by indicating whether a default is likely on a specific bond issuance; investors can then use the information to decide whether to invest.

What does a bond's rating reflect?

In the simplest terms, a bond's rating reflects the likelihood that an issuing company will be able to repay its debt. When you invest in a company's bonds, you want to be confident that the company can actually pay you back when the bond matures. If a particular bond receives a low rating, you might think twice before investing.

All three ratings agencies use letters to provide insight about bond quality. Bond ratings earlier in the alphabet are considered better than those later in the alphabet, and having more letters is generally better than fewer. Either way, bond ratings are scaled differently depending on the rating agency, and it's important to know the similarities and differences across rating firms.

For Standard & Poor's, AAA is the best rating, followed by AA, A, BBB, BB, B, CCC, CC, and C. D is used for bonds that are already in default, which means the underlying company isn't able to pay back principal. Fitch's ratings are similar to S&P, while Moody's uses a slightly different scale, but its Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C ratings have roughly the same meaning.

From there, numbers or symbols further break down the letter-based rating. For example, with S&P and Fitch, a rating of AA+ is better than AA, and a rating of AA- is worse than AA but better than A+. Moody's uses numbers to indicate relative quality, with Aa1 being the best Aa rating, followed by Aa2 and Aa3.

Bond ratings chart

Review and compare ratings across the three agencies.

Bonds with triple-A ratings are considered the safest investments available. As you scan down the chart, credit quality decreases and risk increases. Debt rated below BBB- will pay a higher rate of interest to the bondholder but will also come with a much greater risk of default.

How are bond ratings determined?

Rating agencies undertake a tremendous amount of due diligence on an issuer (a company issuing bonds) before coming up with a rating. Agencies review, analyze, and synthesize data from the issuer's financial statements and then issue a rating based on financial ratios and other non-financial information. When coming up with a score, rating agencies might also consider relationships with local government agencies or a parent corporation, as well as broad economic conditions at the time of bond issuance.

A bond's rating can be a quick and useful way to get a sense of a company's ability to repay its bondholders. However, it's not a perfect measure, and changes to a company's underlying fundamentals -- or a swift change in macroeconomic conditions -- can cause unusual financial outcomes. Still, on the whole, ratings agencies try to keep the investing public informed about the financial health of any issuing company.

Investment grade vs. speculative grade bonds

Bonds rated above BBB- (or Baa3 in the Moody's rating scale) are considered investment-grade. This means that most institutional investors are permitted to own the bonds. Bonds rated lower than BBB- are considered speculative, which is another way of saying, "Invest at your own risk." Bonds with speculative ratings typically have issuers with questionable liquidity and solvency measures.

Investment-grade bonds typically pay a lower rate of interest due to their higher credit quality; the probability of receiving your principal back is considered high with these securities. Speculative-grade bonds, on the other hand, pay a higher rate of interest to compensate the investor for the higher probability of issuer default. Speculative bonds are also sometimes referred to as "junk bonds."

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The bottom line

Rating agencies attempt to consolidate a company's financial health into a letter rating, which is quite useful for investors. The investing public is unquestionably better off to have independent organizations performing deep analyses for potential bond buyers.

To some investors, bond ratings may feel oversimplified. However, even though bond ratings aren't ironclad guarantees of investment success, they're a great place to get started when it comes to researching a company's debt . Before purchasing bonds of any quality, be sure that you understand what you're buying and how they fit into your overall financial picture.