A bond is a commitment from an issuer to pay the purchaser in the future. This is a promise for the future, and the ability of the issuer to fulfill this promises is dependent on a number of factors, and most important of them is the issuer’s financial stability.
Bond ratings provide the investor a professional estimate of the bond issuer’s ability to fulfill its commitment.
Recognized Rating Organization
There are a number of companies in the US that rate bonds, but only three of them are considered recognized rating organizations by the SEC.
- Standard & Poor’s.
Investment managers that work for institutions such as pension funds and the like are only allowed to rely on the ratings provided by recognized rating organizations.
Each rating company has a scale with a number of different levels. Both S&P and Fitch have a scale with ten different grades, and Moody’s has one with 9 possibilities. The scales are presented in descending order, with the best rating at the top, and the lowest ones on the bottom.
The Three Recognized Rating Organizations Ratings Scales
|Very Low Risk||AAA||AAA||Aaa|
|Lower Than Average Risk||A+
|Higher Than Average Risk||BB+
|Very High Risk||CCC+
|Real Chance of Defult||CC||CC||Ca|
|The Issuer is ob the Verge of Defauiting||C||C||C|
|Default (Fitch’s subdivisionss present the posibillity that the issuer will be able to get out of default)||DDD
Bonds receive their first rating when they are issued. However, since the financial stability of the issuer can change with time, the rating companies continuously follow the issuers’ financial situation and periodically change their ratings.
When a rating company thinks that it will soon need to change a bond’s rating, it issues a special warning. Generally, a warning like this has an immediate affect on the bond’s market price.
Bonds are split into three different categories.
- Investment Grade
This group includes bonds rated BBB- and above. (Baa3 in Moody’s scale).
- High Yield or Speculative Grade
These are bonds with a rating less than BB+. (Below Ba1 according to Moody’s).
- Junk Bonds
Bonds with a rating below CC are placed here. (Below Moody’s Ca).
The law forbids institutional investors in the United States from investing in bonds rated less than BBB-.
Bond ratings are important for issuers as well. If the rating is higher, then investors will see them as being more secure and will be willing to accept lower yields.
The rating companies rate the majority of bonds that are issued on their own initiative and update those ratings as necessary. This rating is not paid for by the bond issuers and is based on information that is available to the public.
If a bond issuer wants a rating company to have access to confidential information, he needs to pay for the rating. Of course, issuers will only choose this option if they think that revealing the additional information will be to their advantage.
Do Ratings Work?
Generally, the financial community treats the bond ratings from the recognized rating organizations very seriously, and considers them completely objective.
Empirical studies show that the bond ratings generally give an exact picture of the bond issuers’ financial stability. For example, in the twenty seven years between 1971 and 1997:
- Of all the corporate bonds rated AAA by S&P when they were issued, none of them defaulted within their first year. Only 0.06 percent of them defaulted within ten years of being issued.
- Of the bonds that were rated CCC when they were issued, two percent defaulted within their first year and 47 percent defaulted within ten years.
The Difference between Bond Rating and Credit Rating
It is important to differentiate between Bond Ratings and Credit Ratings. A bond rating is given to a specific series of bonds, and it is possible that a company will have a number of different bond series, and that each will have a different rating. For example, a series that matures within a year is likely to have a higher rating than one which only matures in twenty years.
A credit rating, on the other hand, is given to a company as a whole, and is meant to assists its creditors in estimating the company’s ability to meet its financial obligations.
Information on specific bonds’ ratings and announcements regarding expected changes can be found at rating companies’ websites and in the guides that they regularly publish.