A bond rating is an assessment of the creditworthiness of the bond's issuer. It is a prediction of the likelihood that a company, a government, or another entity will default on its debt obligation.
Bonds are rated by one of three credit rating agencies that grade them on a scale of AAA to D or Aaa to D. The grading system varies slightly among the agencies.
The ratings are used by investors to judge the riskiness of a bond investment. The ratings also influence the return on the bond. A lower rating requires a higher return on the bond in order to compensate for the added risk the investor is taking on.
Bond ratings are meant to be independent and objective assessments of the creditworthiness of companies and countries.
Key Takeaways
- A bond credit rating is a shorthand assessment of a company's creditworthiness, measuring the likelihood that it will default on its bonds.
- Bond credit ratings are issued by rating agencies to help investors determine the riskiness associated with investing in bonds issued by a company, a government, or a government agency.
- Credit ratings range from the highest credit quality on one end to default or "junk" on the other.
- A triple-A (AAA or AAa) is the highest credit quality, and C or D (depending on the agency issuing the rating) is the lowest or junk quality.
Understanding Corporate Bonds
Bonds are debt securities that are sold to raise funds to invest in the long-term future of the company or other entity that issues them.
A corporate bond is a debt instrument or IOU. The investor pays the company the value of the bond upfront. This is the principal amount.
In return, the company pays the investor interest (called a coupon rate) via periodic interest payments. At the bond's maturity date, typically in one to five years from its issue date, the principal is paid back to the investor.
Before investors buy a corporate bond, they need to know how financially stable the company is that's issued the bond. In other words, investors need to know whether the company will be able to meet its financial obligations.
If a company didn't pay back its investors the bond's principal amount, the corporation would be considered in default, or nonpayment, of the bond. The risk that a company might not pay back the principal amount of a bond is called default risk.
Credit in the Investment World
As investment opportunities become more global and diverse, investors need to determine which companies in which countries are good investment opportunities.
There are advantages to investing in foreign markets, but there are more risks associated with sending money abroad than investing in the domestic market.
It is important to gain insight into different investment environments and to understand the risks and advantages these environments pose. Credit ratings are essential tools for helping investors make informed decisions.
The Rating Agencies
Globally, there are only three main rating agencies: Moody's, Standard& Poor's (S&P), and FitchRatings. Each of these agencies aims to provide a rating system to help investors determine the level of risk associated with investing in a specific company, government, agency, investment instrument, or market.
Ratings can be assigned to short-term and long-term debt obligations that are issued by a government or a corporation, including banks and insurance companies.
For a government or company, it is sometimes easier to pay back local-currency obligations than to pay foreign-currency obligations. The ratings, therefore, assess an entity's ability to pay debts in both foreign and local currencies. A lack of foreign reserves, for example, may warrant a lower rating for debts a country took on in a foreign currency.
Ratings are not the same as the buy, sell, or hold recommendations issued by investment companies for stocks. The ratings measure only the issuing entity's ability and willingness to repay debt.
The Rating Spectrum
For long-term issues or instruments, the ratings lie on a spectrum ranging from the highest credit quality on one end to default or "junk" on the other.
A triple-A (AAA) is the highest credit quality. A C or D (depending on the agency issuing the rating) is the lowest or junk quality.
Within this spectrum, there are different degrees of each rating, which are, depending on the agency, sometimes denoted by a plus or negative sign or a number.
Investment Grades
For Fitch Ratings, a triple-A or AAA rating is the highest investment grade and signifies that its debt is an exceptionally low credit risk. A rating of AA+ represents very high credit quality; An "A" means high credit quality, and BBB is a satisfactory credit quality.
All of these ratings are considered to be investment grade. This means that the security or entity being rated carries a high-enough quality level for most financial institutions to make investments in those securities.
BBB is the lowest rating of investment-grade securities, while ratings below "BBB" are considered speculative or junk.
The letters vary slightly by agency. For Moody's, a Ba is a speculative or low-grade rating, while for S&P, a "D" denotes default of junk bond status.
Many investors and financial firms never invest in bonds rated "junk."
Investment companies that offer bond funds indicate the ratings of the bonds they invest in. Some invest only in investment-grade funds. If they buy any lower-rated bonds, the percentages of the fund invested in lower-rated bonds are stated in the investment profile.
The followingchart gives an overview of the rating symbols that Moody's and Standard & Poor's issue:
| Bond Rating | |||
|---|---|---|---|
| Moody's | Standard & Poor's | Grade | Risk |
| Aaa | AAA | Investment | Lowest Risk |
| Aa | AA | Investment | Low Risk |
| A | A | Investment | Low Risk |
| Baa | BBB | Investment | Medium Risk |
| Ba, B | BB, B | Junk | High Risk |
| Caa/Ca/C | CCC/CC/C | Junk | Highest Risk |
| C | D | Junk | In Default |
Sovereign Credit Ratings
A rating can refer to a specific financial obligation or to the general creditworthiness of the entity that issues it.
A sovereign credit rating provides the latter. It signifies a country's overall ability to provide a secure investment environment. This rating takes into account a country's economic status, the transparency of its capital markets, levels of public and private investment flows, foreign direct investment, foreign currency reserves, and its political stability.
A sovereign credit rating is, therefore, an indication of the viability of a country's investment markets. It is the first metric that most institutional investors look at before investing internationally.
Most countries strive to obtain and retain an investment-grade sovereign rating in order to attract foreign investment.
A US Downgrade
In August 2023, Fitch downgraded the United States to AA+ from AAA, citing expected fiscal deterioration over the next three years, a growing government debt burden, and an erosion of governance relative to its peers.
Controversies
While the rating agencies provide a robust service, the value of such ratings has been widely questioned since the 2008 financial crisis. A key criticism is that the issuers themselves pay the credit rating agencies to rate their securities.
As the real estate market soared, huge amounts of subprime debt securities were being rated by the agencies. The competition for feespromptedthe three agencies to issue the highest ratings possible.When the housing market began to collapse in 2007-2008, the rating firms were disastrously late in downgrading subprime debt that had become worthless.
To help resolve potential conflicts of interest, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act mandated improvements to regulating credit rating agencies. Under the rules, credit rating agencies have to publicly disclose how their ratings have performed.
They also can now beheldliable for ratings that they should have known were inaccurate. In 2013, Standard & Poor's, Moody's, and Fitch Ratings were sued for assigning artificially high credit ratings to the mortgage bondsheld in aBear Stearns hedge fund.
A good investment management firm or bank does not rely solely on a bond rating from a credit agency to determine if an investment is safe. Typically, the in-house research department will help make the determination.
Investors can also perform due diligence by questioning the initial bond rating and reviewing the rating for any changes over the life of the investment.
Does a High Credit Rating Guarantee a Safe Bond Investment?
There are no guarantees in investing.
A high credit rating for a bond indicates that the entity that issued it was financially sound and was willing and able to pay its debts at the time that one of the rating agencies examined its finances.
It does not address other risks inherent in bond investing, such as the risk that a later spike in interest rates will render a bond less profitable than newer bond issues.
Moreover, there is a potential conflict of interest in the bond rating system. The entities that issue bonds pay for them to be rated. That issue was addressed in regulatory reforms put into place after the 2007-2008 financial crisis but the system was not totally overturned.
Are Foreign Bonds a Good Investment?
Foreign bonds are attractive to some investors as a way to diversify their portfolios and add some exposure to growing international markets. They often pay higher interest than domestic bonds. But that is because they carry additional risks.
One of those risks involves working with two currencies. The investor is converting U.S. dollars to a foreign currency in order to purchase the bonds. The interest is converted from a foreign currency and the principal is finally repaid in converted currency. Those conversions can come at an inopportune time, depending on the changing values of both currencies.
Of course, there also is the matter of geopolitical risk. Some nations are more stable than others. That is why a bond's rating is a crucial indicator of the relative safety of a bond investment.
What Is an Investment-Grade Bond?
An investment-grade bond has a grade of AAA, AA, A, or BBB.
The ratings agencies use slightly different designations. Standard & Poor's highest rating is AAA while Moody's calls its highest rating Aaa.
Regardless, any bond rated BB (or Bb) or less is considered too risky to be termed investment grade. It is deemed a "junk bond."
Junk bonds are sometimes termed "high-yield" bonds. They do pay higher interest rates than investment-grade bonds because they carry a higher risk of default.
The Bottom Line
A credit rating is a useful tool for both the investor and for the entities seeking investors. An investment-grade rating can help a company or a country attract both domestic and foreign investments.
For emerging market economies, a solid credit rating is critical to demonstrating creditworthiness to foreign investors.Moreover, a better rating typically means a lower interest rate, reducing the costs of raising money.
