Investing > Bond Ratings Explained

Bond Ratings Explained

From the investor’s perspective, ratings are what give bonds their value—they are a self-fulfilling prophecy that come with many advantages for the market.

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Updated April 16, 2022

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In video games, enemies often have a level bar above their heads. This allows the player to calculate how risky it would be to attack the enemy and try to steal his precious loot. 🐉

The bond market is kind of similar to a video game in that sense—every bond has a rating that tells us how likely it is to fail and lose value. Naturally, issuing bonds is a key method for governments and companies to raise funds, so having a good rating is essential for any issuer.

For example, after Russia’s military operation in Ukraine started, the biggest ratings agency—Standard and Poor’s—lowered Russian government bonds’ rating to “selective default” which led the bonds to be traded for as little as 34 cents on the dollar. Just like a scary looking lizard-person in a video game, low-rated bonds are evaded by all but the most adventurous market participants, even though they hold greater rewards than their low-risk counterparts.

However, real life is not a game, and it is definitely not a game when long-term investments are involved. That’s why it is crucial for any bond investor to know how bond ratings work, and at what point something is too risky. 🚧

In this article, we will discuss the importance of ratings, their impact on bond prices and yields, and how each of the 3 biggest rating agencies scores their customers’ bonds. Let’s get straight to it.

What you’ll learn
  • The Definition of a Bond Rating
  • Understanding Bond Ratings
  • How Are Bonds Rated
  • Bond Rating Agencies and Rating Scales
  • Pros and Cons
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

The Definition of a Bond Rating 👨‍🏫

Bond ratings are a measure of a bond issuer’s creditworthiness. The ratings are determined by rating agencies that produce evaluations of the bond issuer’s financial health, as well as their ability to repay the bond’s interest and principal according to the contract signed with the buyer of the bond.

Since the rating of a bond has a huge impact on its desirability and thus price, the rating agencies act as crucial institutions of the financial system even though they are private independent companies. To be exact, the rating agencies are 3 private companies—Moody’s, Standard & Poors (S&P), and Fitch—that together produce over 90% of the bond ratings in the U.S. and many ratings worldwide.

Each company uses a slightly different rating methodology, but all of them measure a bond’s investment quality grade and its level of risk. These ratings are made by professional analysts, and retail investors along with institutions use them to guide their bond purchases.

Understanding Bond Ratings 📚

In the good old days, investors would get their ratings through haruspicy, but nowadays, rating agencies have a strict research protocol for every new bond they intend to rate. Before anybody would buy a bond, the rating agencies need to conduct a thorough analysis of the bond issuer’s financials through which they can get a very clear idea of how likely the issuer is to honor its contract.

Rating agencies look at the issuer’s cash flow, cash reserves, debt levels, etc. to tell buyers how safe a bond is. If the company is very financially sound, it will get a good rating, whereas bonds that are more speculative as investments get lower scores—although these bonds often have higher yields to make up for their inherent risk.

All 3 major rating agencies are Nationally Recognized Statistical Rating Organizations (NRSRO) that are regulated by the U.S. Securities and Exchange Commission (SEC), which makes them as official as they get. Even though the agencies are nationally recognized, they have been known to make mistakes or even indulge in bad business practices that were essential for the rise of subprime mortgage debt that caused the 2008 financial crisis.

How Are Bonds Rated? 🤔

Oddly enough, making bond ratings the way they are made is not something that can be done by an AI—at least not quite yet. According to Moody’s rating policy, the agency does a survey asking market participants about what they need in order to make better investment choices.

Then, the first step in rating a security is a special sort of analysis. Moody’s conducts a thorough fundamental analysis using the information given to it by the issuer—according to Moody’s documents, this information also includes non-public confidential data that might be extremely important to determine credit risk. That is their way of saying they can produce better ratings than us ordinary folk. 🧮

Going forward, this analysis includes an estimation of the value of all of the issuer’s assets, its financial statements, and management quality. Then, models are run to predict all possible outcomes of a number of likely market scenarios—this is a bit tricky because what Moody’s considers to be an improbable scenario will be weighed more lightly in the final rating.

For example, this mistake was made on a systematic level before, either intentionally or unintentionally, and was one of the causes of the 2008 Global Financial Crisis

At the end of Moody’s rating policy, it says that the ratings themselves are made to suit the interest of the investors and not the issuers who hired the agency. Even though this seems like a conflict of interest that might raise suspicion in some, there is no denying that Moody’s has a strict, standardized protocol that has almost always worked perfectly and allows investors to compare securities easily and without additional cost to themselves.

Bond Ratings Influence Pricing, Yield, and Long-Term Outlook 🔍

Bond ratings are key to analyzing the markets. If ratings are very good overall, that means that the economy is healthy—and if ratings are bad by and large, that’s a sign of trouble.

If a bond has a very good rating, that means that the rating agency thinks that there is almost no conceivable chance that the issuer will default on his obligations. A high rating equals an extremely safe bet—and that is why the highest-rated bonds are usually the ones with the lowest yields. 📉

If a bond were to have a high yield and a great rating, it would probably be very expensive—as long as a top-rated bond offers a higher payout than a Treasury bond, it can be sold for more to make up for that difference. 

However, each bond issuer is under examination here and if it doesn’t seem like they will be able to meet their obligations long-term, their bond’s rating and price will suffer—in this case, an issuer is forced to find funding by promising higher yields, which in turn make their bonds a bit riskier, but substantially more profitable. As these securities are more speculative, they are commonly called “junk bonds” and are not recommended as a means of making an investment portfolio safer.

💡 Keep in mind: Finding up-to-date ratings for bonds and other securities is very easy—even apps used for trading stocks show the most recent ratings from the 3 major rating agencies.

How Are Junk Bonds Rated? 👷‍♂️

Everything below BB or Ba level is considered a junk bond. The process behind rating junk bonds is the same as with any other bond but the asset class they fall into as risky bonds is completely different.

High-tier bonds (BBB or higher) are considered nearly invincible in all market scenarios short of a crash of epic proportions. Junk bonds, on the other hand, have higher yields but might become worthless because there is a chance that the issuer will default on them. 

This makes junk bonds an especially risky asset type because the potential downside is losing all your money, whereas the upside is getting paid at a rate that can hardly combat inflation. For example, in April 2022, the inflation rate was estimated at 8.5%, whereas BofA’s high-yield BB bonds only had an average yield of around 5.37%. 📈

As a risk asset, junk bonds are hardly a good substitute for good growth stocks and even blue-chip stocks. Only an issuer in dire need of money and little means to pay it back would issue a high-yield bond that would outpace inflation and perhaps even the stock market average—moreover, if they default on their debt, your investment can go to zero, whereas it is highly unlikely for a blue-chip company to go under (and it will still probably match the average market return). Hence the bad score and the name.

Bond Rating Agencies and Rating Scales 📊

Each of the big 3 rating agencies pretty much does the same job, but their end products look a bit different. Each rating system is very intuitive but knowing what a rating means exactly for all of the 3 agencies can help investors choose their new bond investments with a bit more awareness.

Standard & Poor’s Bond Rating Explained 📜

The famed Standard & Poor’s Global Ratings (S&P) is the first and most popular among the Big Three. The company produces thousands or even millions of ratings each year for various types of securities.

The company also provides GSC ratings (that measure the quality of governance in a company), GAMMA ratings (that measure governance, accountability, and management), and other governance and management scores that are very important for ESG stocks—ESG companies tend to attract investors with their ethical yet efficient business practices.

Here is how Standard & Poor’s bond rating works:

RatingCriteriaGrade
AAAExtremely capable of meeting financial obligationsInvestment
AAVery capable of meeting financial obligationsInvestment
ACapable of meeting obligations but somewhat vulnerable to changes in economic circumstancesInvestment
BBBCapable of meeting obligations, but more vulnerable to economic changesInvestment
BBNot very vulnerable short-term, but very susceptible to economic changes in the long termSpeculative
BEven more vulnerable to changes in market conditions but able to meet financial obligations at the momentSpeculative
CCCDependent on current market conditions to be able to meet financial obligationsSpeculative
CCVery susceptible to market conditions—a future default is a very distinct possibilitySpeculative
CCurrently unable to meet financial obligations and expected growth will not be able to repay its higher-rated debtSpeculative
DFinancial obligations haven’t been met and a promise was breached / a bankruptcy petition has been filedSpeculative
NRNot ratedSpeculative

All in all, an investment-grade bond is something one can buy without feeling any pressure as these bonds should be safe unless an extreme market scenario like the Great Recession unfolds. On the other hand, bonds of the speculative grade are far more susceptible to anything that happens in the market or the real economy, and the lowest-rated among them are nearly certain failures.

How Moody’s Rates Bonds 📝

As the most widespread rating agency, Moody’s Corporation provides ratings for tens of thousands of financial entities in over 130 countries. As this is a huge rating agency, a great number of bonds on the market use its ratings—and this is important because Moody’s uses a slightly different system that can be misinterpreted (not that likely, though).

Unlike Fitch and S&P, Moody’s focuses on one question—how risky is this bond if things really go south? Each rating essentially describes how likely—in Moody’s opinion—a bond is to fail in any way and if the issuer has the resources to pay its debts even if disaster strikes. The bonds with the best ratings should be virtually impossible to fail and low-rated contracts are likely hazardous for your portfolio.

RatingCriteriaGrade
AaaTop-quality bond, minimal riskInvestment
AaHigh-quality bond, very low riskInvestment
AHigh-medium-grade bond, low riskInvestment
BaaModerate risk level bond, non-negligible credit riskInvestment
BaSomewhat speculative bond, substantial credit riskSpeculative
BSpeculative bond, high credit riskSpeculative
CaaLow-quality bond, very high credit riskSpeculative
CaVery speculative, in default or very near it, low chance of recoverySpeculative
CLowest-grade bond, with very little chance of recoverySpeculative

As you can see, this rating system was designed by someone who dislikes excessive capitalized letters and loves the uncapitalized “a.” But other than looking a bit different, it tells a very similar story to that of S&P’s rating system. 

Whereas S&P and Fitch look at the issuer’s ability to earn and retain the funds to pay its bondholders, Moody’s is a bit more pessimistic (hence the name, probably)—it focuses on telling investors how likely they are to lose and how much in the case of a default. In a manner of speaking, Moody’s ratings are a bit more defensive and focus on the worst as a welcome precaution.

Fitch Bond Rating Scale 📃

Despite being the smallest of the big 3 agencies, Fitch Ratings Inc. still covers a large variety of sectors. The system looks the same as S&P’s and calculates the likeliness of default—the only difference is the rating methodology which doesn’t always produce the same results as S&P’s would.

RatingCriteriaGrade
AAAExtremely capable of meeting financial obligationsInvestment
AAVery capable of meeting financial obligationsInvestment
ACapable of meeting obligations but somewhat vulnerable to changes in economic circumstancesInvestment
BBBCapable of meeting obligations, but more vulnerable to economic changesInvestment
BBNot very vulnerable short-term, but very susceptible to economic changes in the long termSpeculative
BEven more vulnerable to changes in market conditions but able to meet financial obligations at the momentSpeculative
CCCDependent on current market conditions to be able to meet financial obligationsSpeculative
CCVery susceptible to market conditions—a future default is a very distinct possibilitySpeculative
CCurrently unable to meet financial obligations and expected growth will not be able to repay its higher-rated debtSpeculative
DFinancial obligations haven’t been met and a promise was breached / a bankruptcy petition has been filedSpeculative
NRNot ratedSpeculative

All in all, Fitch provides extremely similar ratings to that of its biggest competitor, making this rating system very non-unique. However, standardization hardly makes things more difficult. 

Pros and Cons of Bond Rating Agencies ⚖

Rating agencies are hired by the issuer. In a sense this is like a judge being paid by the defendant—there is an inherent conflict of interest involved. Even though rating agencies say they strive to help the investor and provide absolutely objective ratings to the market, their conduct during the housing market bubble showed otherwise when it turned out that many debt securities were overrated, and thus, overpriced, and thus, in a bubble that popped like a bomb in 2007.

However, if we disregard the possibility of corruption and negligence in the agencies and the government institutions that oversee them, we can see all the positives of having bonds rated for us by experts. Even though rating a bond would be doable for an advanced investor, the sheer volume of work it would take is astronomical, so rating agencies are necessary for today’s security market to function at full capacity.

Furthermore, all 3 major agencies have provided very accurate ratings in the past, as seen when we analyze credit default rates across ratings—even at the peak of the 2008 crisis, AAA-rated municipal bonds only suffered a 0.53 default rate, which at that point had been around 0 for the past 30 years. As a reference, B-rated bonds had a 12.84 default rate overall that year, so the difference between these two grades is extreme.

All in all, bond rating agencies provide a huge service for all market participants, lowering the cost of getting information about the risk involved with a debt security. However, no service in capitalism is free, and the inherent conflict of interest that the rating agencies have might lead to unobjective ratings—although the SEC has been on the rating agencies’ case a lot more since 2008, so it is not too likely.

Conclusion 🏁

Bond ratings serve to tell the investors whether a bond is risky, and how much. As the amount of work that an analysis of credit risk would take is huge, the 3 major rating agencies provide this info to the investor, free of charge—ratings are necessary for the bond market as very few investors would buy a bond with unknown credit risk. 

The 3 rating systems have differences, but are more similar than they are different—without going too much into depth, any investor can quickly determine the merit of investing in one bond over another.

How Bonds Are Rated: FAQs

  • What Does a Bond’s Rating Actually Measure?

    A bond’s rating measures credit risk. Essentially, this is the likelihood of the bond’s issuer defaulting on its obligations. 

  • What is a Good Bond Rating?

    An investment-grade investment is considered safe in any scenario short of a major economic event, and thus, a good investment. For S&P and Fitch, investment-grade bonds are rated AAA through BBB, and for Moody’s, they are rated Aaa through Baa.

  • Why Are Bond Ratings Important to Investors?

    By looking at bond ratings, investors can determine whether a bond is worth investing in or not without doing research. Rating agencies thoroughly analyze the issuer’s financial health and future growth prospects to determine a rating that will accurately present the level of risk that each bond holds to investors.

  • How Does a Bond Rating Affect Its Price?

    As an investment category, bonds are desirable because of their safety and predictability. If a bond is unsafe and the underlying organization is in risk of defaulting, the bond’s rating will reflect that, discouraging most investors from buying, and thus, lowering its price.

  • Are Bond Ratings Reliable?

    Even though credit agencies adhere to strict and comprehensive rating protocols, they have been known to provide inaccurate or outright wrong ratings—this was one of the likely causes of the housing bubble in 2007. Thus, hedge funds, banks, and professional money managers don’t rely solely on ratings for their bond research.

  • What Are Bond Ratings Based On?

    Bond ratings are based on the financial strength of the underlying company or organization, but also their vulnerability to changes in market conditions. A company with low debt, strong cash flow, and a big economic moat will get a better rating than a company that is dependent on current economic conditions and is barely able to pay its debts.

  • What is the Safest Bond Fund?

    All funds that hold triple-A rated assets are considered safe, but the chief among them are Treasury bond funds. Short-term corporate bond funds and municipal bond funds are also considered safe and—as diversified investments—are certainly safer than investing in an individual bond.

  • Is an A-Rated Bond a Low-Risk Investment?

    Yes—A-rated bonds are considered safe investments because they are considered by the rating agencies to be infallible in case of anything less than a major economic disaster. However, unlike AAA bonds, A bonds are somewhat susceptible to market changes, which means that there is a certain risk of default if the underlying company is too adversely affected by an economic event.

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