Think of a bond rating as a school report card. Companies have ranking for bonds based on the likelihood of the bond defaulting on its invested amount
Now that we’ve tackled bond premiums, it’s time you learn about bond ratings and why they are so important to understand.
What is a bond rating?
Think of a bond rating like a report card for the bond market. Schools give letter grades to students. They are based on the likelihood of the bond defaulting on its invested amount. Investment companies generally require bond issuers to have at least two ratings from those and other rating companies.
The rating companies examine and weigh the investment risk of a bond. The ratings can be thought of as risk assessments and are judgments on the credit strength of the companies and their risk for defaulting — not paying — on their debt obligations.
Investors can look at the rating for a particular bond and see if the investment would be low risk — bonds with a higher rating, or higher risk — bonds that have lower ratings.
The ratings systems are based on a letter grading system, A through D, with the AAA being the highest level a bond issuer can achieve.
The S&P’s bond ranking uses the following ratings, so let’s use this as an example:
AAA and AA Bond Rating
If a bond has these ratings, the investor can be assured that it is a high credit-quality investment grade.
AA and BBB Bond Rating
While not as secure as the higher levels, bonds with these ratings are considered medium credit-quality investment grade.
BB, B, CCC, CC and C Bond Rating
Bonds with these ratings are low quality grade bonds, also known as junk bonds or non-investment grade bonds.
D Bond Rating
Bonds that have this rating are already in default for non-payment of principal and/or interest.
Impact of Bond Ratings
Financial analysts say the rating of a bond affects a company’s ability to secure lucrative interest rates for its debt and the amount of funds a company can go after — which could impact bond price.
In general, a bond with a higher chance of default — with the investor being out of money — would be lower priced than a secure AAA investment with a low chance of default.
Other financial experts point out that these ratings are mere opinion and not an accurate judge of a bond’s worth or the company’s ability to pay back its investors.
Bond Rating Agencies
Every 6-12 months, rating agencies review bond ratings. A bond may be reviewed at any time the agency deems necessary, though. Reasons for this are missed or delayed payments to investors, issuance of new bonds, changes to an issuer’s underlying financial fundamentals, or other broad economic developments.
Institutional and individual investors rely on bond rating agencies and their in-depth research to make investment decisions. Rating agencies play an important role in the investment process and can make or break a company’s success.
Bond Rating Tips
While the rating agencies provide a robust service and are worth the fees they earn, the value of such ratings has been widely questioned since the 2008 financial crisis, and the agencies’ timing and opinions have been criticized when dramatic downgrades have come very quickly.
Investors should not rely solely on the bond rating agency’s rating and should supplement the ratings with their own research. It’s also important to frequently review the ratings over the life of a bond.
Curious about bonds and their ratings? Check out this course on Investing In Different Markets.