Bond Ratings: What They Are and Why They Matter

Key Takeaways

• Bonds ratings are used to gauge a bond’s creditworthiness, which correlates with an issuer’s borrowing costs. 

• A bond issuer’s financial robustness, or its ability to pay a bond’s principal and interest when due, is evaluated by private independent rating services such as Moody’s Investors Service, and Fitch Ratings.

• Whether the bonds are U.S. Treasuries or from global corporations, agencies establish bond ratings by performing a comprehensive financial analysis of a bond’s issuing body.

It is imperative that investors who seek to analyze the creditworthiness of bonds, understand bond ratings, who assigns them, the factors involved, and their implications. With that said, let’s dive in bond ratings: what they are and why they matter. 

What is a Bond Rating?

Just as individuals have their credit history rated by credit bureaus, bond ratings are used to gauge a bond’s creditworthiness, which correlates with an issuer’s borrowing costs. 

Put another way, the ratings are tools investors use to swiftly gauge a bond’s credit quality. They may be thought of as the credit scores of companies and local and federal governments.

A bond’s credit quality is indicated by a letter grade by a private, independent ratings service such as Standard & Poor’s. Specifically, credit ratings indicate the likelihood of repayment as per terms of the insurance. 

Higher-rated bonds, also called investment grade bonds, are considered more stable and safer investments, with low default rates. These offerings derive from government entities and publicly traded corporations that have positive outlooks, and usually have ratings of AAA, AA, A, and BBB.

Junk bonds, on the other hand, usually have ratings of BB+ to D – if they are rated at all, due to their high risk. While they can have high yields, such bonds derive from companies with liquidity issues.

Who Assigns the Bond Ratings?

Typically, a ratings-based letter grade is assigned to bonds that denotes their credit quality. A bond issuer’s financial robustness, or its ability to pay a bond’s principal and interest when due, is evaluated by private independent rating services such as Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. Most bonds have ratings that are provided by at least one of those agencies.

Note that ratings exclusively address credit risk. For example, they do not refer to any risk of market value loss due to interest rate changes, liquidity, or market factors. However, market risk may be factored in, in that it impacts an issuer’s ability to pay or refinance a financial obligation. 

• Standard & Poor’s. S & P uses a plus or minus indicator, and ratings range from AAA to BBB-. The most common AAA-rated bond securities are U.S. Treasury bonds. “Junk” bonds, which are non-investment-grade bonds, typically get ratings of BB+ to D, although such bonds are given “not rated” status. While junk bonds are viewed as higher risk – liquidity issues and the possibility of default — they remain attractive to some investors due to potentially higher yields.
• Moody’s Investors Services. Its ratings span Aaa to Baa3. Junk bonds are usually rated Baa1 to C. Note that Moody’s employs a numerical indicator (for example, while A1 is superior to A2, it is still not as good as Aa3).
• Fitch Ratings. Fitch’s credit rating scale employs the categories AAA to BBB for investment-grade securities, and BB to D for speculative grade bonds. There is also a +/- for AA through CCC levels that indicate comparative differences of probability of recovery or default. 

Factors Considered in Bond Ratings

Agencies establish bond ratings by performing a comprehensive financial analysis of a bond’s issuing body. The process is the same whether the bonds are U.S. Treasuries or from global corporations, although each agency has its own set of criteria.

The focus is on the issuing entity’s ability to pay their bills and maintain their liquidity, while factoring in a bond’s future outlook and expectations, as well as macroeconomic conditions and industry outlook. Based on these data points, the agencies then assign a bond’s rating.

What is the Rating Scale?

Investment-grade classifications indicate comparatively low to moderate credit risk. From the ratings agency’s point of view, such bonds are generally considered investment worthy due to their low likelihood of default and reasonable risk level.

Still, investment-grade bonds’ low risk and stability may provide lower returns than higher-risk junk bonds. Speculative-category ratings – as given to junk bonds — denote a higher credit risk level or that a default has already taken place.  Such bonds have scores of BB+/Ba1 or lower. Note that while junk bonds are generally considered less risky than stocks, they may be riskier, as a whole, than equities. That is primarily why such bonds must pay out loftier interest rates.

Ratings among agencies may slightly differ based on the proprietary methodology employed, just as one’s personal credit score may have variations among the top three credit bureaus: Experian, Equifax, and TransUnion.  

Note that whether an issuer is a municipality or corporation, an issuer’s financial health can change. Therefore, ratings agencies may upgrade or downgrade a rating. The possibility of such changes is why it is important to regularly monitor a bond’s rating. For instance, if a bond is sold prior to maturity, any ratings changes can impact the price that investors are open to paying for it.

What are the Implications of the Different Ratings?

The chief purpose of bond ratings is to help investors understand the risks inherent in purchasing fixed-income securities. 

Generally, higher-risk bonds provide higher yields, while lower-risk bonds offer lower yields. Another way to put that is, higher-rated bonds have a lower risk of default, and thus, lower yields. Lower-rated bonds generally carry a higher risk of default and offer higher yields.

Investing in high-risk bonds generally requires a high tolerance for risk. Commensurate with a decreasing repayment likelihood, companies typically offer higher rates to entice lending.

Further, with respect to debts, there are rules concerning what a company may and may not do. Such covenants, as they are known, can also impact a bond’s rating. For example, the amount of overall debt a company can assume following bond issuance could affect the bod’s rating. In such a case, the bond might be considered to have a lower default risk since it cannot leverage itself or assume excessive debt.

In addition, a bond’s rating may also be affected by the volume of assets a company has. In other words, the rating may be impacted by whether a bond is backed by insurance or has real assets that provide backup should the bond be unpaid.

After such factors have been assessed and a grade has been issued, bonds can then be categorized into investment-grade bonds and junk bonds.

Why are Bond Ratings Important to Know for Investors?

Ratings tell investors about the stability and quality of the bond being considered. As a consequence, such ratings significantly affect interest rates, bond pricing, and investment appetite.

In fact, there is widespread belief that the rating agencies contributed to the 2008 economic downturn when, in the runup, they were said to have falsely inflated bond ratings, and thus the bonds’ value. In 2008, a year after Moody’s gave mortgage-backed securities an AAA rating, the service downgraded 83 percent of $869 billion in them.

Whether opting to purchase individual bonds or funds, investors would do well to remember that rating agencies look solely at a company’s current situation. For instance, if a projected income source is weakening, that condition may not have yet been accounted for in their assessments.

Also, while bond ratings reveal credit rating agencies’ opinion as to the likelihood of default, such ratings do not tell investors whether an individual corporate bond would be a good investment. Such ratings do not mull the price at which a bond is trading, nor do they contemplate its yield.

Corporate ratings do not address a corporate bond’s investment’s relative value since they do not consider an issuer’s corporate bond prices, how credit spreads compare to similar bonds, or how investors should size up corporate bonds’ varying risk/reward opportunities.

Further, bond ratings do not factor in a bond’s interest rate risk, or the corporate bond’s sensitivity to changes in underlying Treasury yields.

Instead of going through scores of individual bonds, the average investor usually puts their capital in bond funds that have a diversified mix of bonds with certain ratings.

After all, diversification is a bedrock of long-term successful investing. The practice spreads capital across a variety of investments and asset classes, which helps to lower risk and could potentially lead to higher returns. 

Diversification and Alternative Investments 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Bond ratings are very important to most investors because they indicate creditworthiness. They reflect an assessment of the bond’s issuer’s financial might or ability to pay a bond’s principal as well as interest. Do note that a bond rating is but one instrument investors can use to measure bond investments.