Bond ratings are an assessment of the ability of a company or government to pay back its debt.
They’re an important part of any investor’s due diligence process, but they’re not the final word on a bond’s quality.
In this post, we’ll look at how bond ratings work and some common misconceptions about them.
Bond Ratings Are Important
Bond ratings are an important part of the financial world, so knowing how they work is important.
While there are many different kinds of bond ratings, like credit ratings and financial risk scores, we’ll focus on understanding the basics of the most common type of bond rating known as a Moody’s rating.
Moody’s bond ratings provide a measure of how likely it is that an issuer will default on its obligations (bonds).
A higher-rated credit is perceived by investors as being less risky than one with a lower rating — and therefore tends to pay less interest over time.
Corporate Bond Ratings
The corporate bond is issued by a company as a way to raise money.
The bonds can be sold in various tranches, with different levels of risk and returns. There are several different types of corporate bonds:
- Investment-grade debt — Bonds that have an above-average chance of paying back their investors’ principal and interest payments on time. These bonds generally have better credit quality than junk bonds, but may still be subject to default or restructuring.
- Upper-medium grade (junk) debt — These are speculative securities that carry some risk of nonpayment or default; they pay higher yields than investment grade bonds because of this risk premium.
- Lower-medium grade (deep junk) debt — The riskiest category; these are considered extremely risky due to the possibility of severe losses if they were to default on payments.
Sovereign Bond Ratings
What is a sovereign bond rating?
A sovereign bond rating is a rating assigned to debt issued by governments. Just like corporate bonds, governments are rated by financial markets to determine their ability to pay back debts. The same criteria are used in analyzing government bonds as those used for corporate bonds, including:
- Ability to service debt (i.e., pay interest and principal)
- Financial strength of the issuer (i.e., cash flow, profitability)
- Economy-wide factors that may affect the issuer’s ability to meet its obligations
How Bonds Are Rated
Bond rating agencies are companies that provide independent assessments of the creditworthiness of government and corporate debt.
Creditworthiness is a measure of an entity’s ability to pay its debts, so bond ratings are an assessment of how likely an entity will be able to repay the principal and interest on its bonds.
These ratings are based on several factors, including:
- The company’s financial position (assets vs. liabilities)
- Its ability to make timely payments (cash flow)
- Its business prospects
The Three Major Rating Agencies
The three major rating agencies are Moody’s, S&P and Fitch.
While these companies may have different opinions on the same company, they all use the same basic criteria to determine a bond’s creditworthiness.
Can Bond Ratings Change?
Bond ratings can change for many reasons, including a restructuring or default of the issuer.
However, these changes in a rating may not have anything to do with the company or its bonds.
In fact, they may have nothing whatsoever to do with either the company or the bond itself.
In some cases, rating agencies will change their ratings based on what’s happening in other markets and economies that aren’t related to those being analyzed: for example, if there is an outbreak of bird flu in China or if Europe decides it needs more austerity measures added onto its existing austerity measures (which are already quite austere).
In other instances, ratings agencies will adjust their positions based on factors such as new laws passed by Congress (such as Dodd-Frank) without necessarily looking at how these changes affect companies’ creditworthiness; they simply make assumptions about these consequences based on past experience with similar legislation and whether those assumptions appear likely given recent events
Investors Need To Do Their Own Due Diligence
While bond ratings are an important tool for investors, they’re not the only tool. Investors should still do their own due diligence on the bonds and companies they’re investing in.
This means investigating and verifying the accuracy of information used to make an investment decision.
Investors should also be aware that even those bonds with high ratings may have risks associated with them, such as credit risk (the chance that a borrower will default on a debt payment) or interest rate risk (the chance that an issuer will be unable to pay off its debts).
As important as bond ratings are, it’s crucial for investors to do their own research and due diligence on the bonds and companies they’re investing in.
For one thing, although ratings agencies make mistakes with some frequency, they’re not infallible.
The rating agency analysts who produce the ratings may make errors in their analysis of a company or its financials.
They may also change their minds about a company’s creditworthiness over time.
For example, Moody’s gave Lehman Brothers an A1 rating at one point; within two years of that rating being issued (and after receiving comments from financial regulators), it downgraded Lehman’s long-term debt to a Ba1.
Second: Ratings agencies are beholden to their clients — for instance, if you want an investment grade rating from any of the major agencies (Moody’s, S&P Global Ratings or Fitch Ratings) for your corporate bonds or municipal bonds issued by your municipality/state/province/country (and most issuers do), then you need to pay them money ($$$$) every year so they will continue issuing these grades on your securities!
This creates potential conflicts of interest between what is best for investors versus what might be best for all parties involved (including but not limited to: corporations themselves).
In summary, we can say that bond ratings are important.
Investors should do their due diligence and make sure they understand what it means when a company’s bond is rated at AA or BBB+, or when a nation’s bonds are rated Aaa by Moody’s or AAA by S&P. But remember: there are no guarantees in investing, so always be careful!
