What You Need to Know About Bond Credit Ratings

When corporations and governments issue bonds, they typically receive a credit rating on the debt's creditworthiness from each of the three major rating agencies: Standard & Poor’s, Moody’s, and Fitch.

These ratings incorporate various factors, such as the strength of the issuer’s finances and its prospects. Ratings allow investors to understand how likely a bond is to default, to or fail to make its interest and principal payments on time.

Learn what the ratings mean to the agencies and what they might mean to investors.

Rating Factors

The bond rating agencies look at specific factors that focus on an entity's capacity to meet its financial commitments by looking at:

• The strength of the issuer’s balance sheet
• The issuer's ability to make its debt payments
• The condition of the issuer's operations
• The future economic outlook for the issuer
• Current business conditions, including profit margins and earnings growth (corporations)
• The strength of their economies (government)

A bond issuer's financial model is essential when ratings are determined. The balance sheet (the financial statement that displays assets, liabilities, and equity) is used in conjunction with the statement of cash flows to determine how a company uses the debt and cash it has.

Each business is rated on the likelihood that they will pay off their liabilities after paying their expenses, and on how they finance their operations.

For countries, the rating includes their total level of debt, debt-to-GDP ratio, and the size and directional movement of their budget deficits. Each agency evaluates the potential impact of changes to a government's regulatory environment and its ability to withstand economic adversity. They also weigh consumer tax burdens, growth outlook, and the political environment.

How to Interpret the Ratings

Standard & Poor’s ranks bonds by placing them in 22 categories, from AAA to D. Fitch essentially matches these bond credit ratings, while Moody’s employs a different naming convention. Within each S&P category between AA and CCC, investments can be assigned a plus (+) or minus (-) symbol, which demonstrates their standing in that category, e.g., AA-, AA+. A minus symbol means they are lower in the category than a bond with only a letter rating, and a plus symbol means they are rated higher than a letter-only rating.

In general, the lower the rating, the higher the yield since investors need to be compensated for the added risk. Also, the more highly rated a bond, the less likely it is to default.

Bonds with ratings between AAA and BBB- are referred to as investment-grade bonds. They are typically viewed as less risky because the bond issuers are more likely to pay off their debts.

Bonds rated at and below BB+ by Standard & Poor's or Fitch, or at Ba1 or below by Moody's, are considered below investment grade or "junk" bonds. The issuers of these bonds have a higher risk of defaulting on their debt.

A high rating doesn’t remove other risks from the equation, particularly interest rate risk. As a result, high ratings provide information about the issuer but can’t necessarily predict how a bond will perform. However, bonds tend to rise in price when their credit ratings are upgraded and fall in price when the rating is downgraded.

What Do Ratings Really Mean?

In plain English, there is no way to know how a bond will perform based on its rating, because the ratings are largely based on historical financial data. Moreover, past performance is not indicative of future financial performance or investment returns. Ratings only indicate the amount of risk certain people see in an investment.

In plain English, there is no way to know how a bond will perform based on its rating because the ratings use past data from company reports. If you've ever heard the saying "past performance is not indicative of future performance or returns" applied to stocks, you can use it for bond ratings as well. All the ratings can tell you is the amount of risk certain people see in an investment.

The Changing Landscape

In 1992, 98 U.S. companies held an AAA credit rating from Standard & Poor's, according to The Financial Times. In Q4 2021, only two U.S. companies had AAA ratings. In recent years, large companies have been more willing to embrace debt as part of an effort to increase perceived value by shareholders.

Shareholders view an increase in debt as an increase in value because a company can usually deduct the interest payments from its taxes, giving it the effect of a value increase because it owes less. On the other hand, equity is more expensive because it cannot usually be written off.

However, investors generally begin to ask more in return for funding a business with higher leverage due to the higher risk of default.

In short, companies take on more risk in the form of leverage to please investors and raise more funds; investors demand more compensation to be happy. Ratings go down because debt goes up, and investors are ecstatic until their investments default. Returns drop and funding goes to the next growing business in line — and the loop continues.

Frequently Asked Questions (FAQs)