Rating bonds

Just as potential lenders turn to credit reporting agencies as a way to check the risk they’d be taking on if they extended credit to you, potential bond investors have turned to bond rating agencies for an opinion of the credit risk they’d be assuming in buying a particular debt security.

The best known US rating agencies are Standard & Poor’s, Moody’s Investors Service, Inc., and Fitch Ratings. These companies assess the creditworthiness of a bond issuer or a specific issue rather than the market appeal of the bond. They look at other debt the issuer has, how fast the company’s revenues and profits are growing, the state of the economy, and how well other companies in the same business (or sovereign or municipal governments in the same general shape) are doing. Their primary concern is to report their view, or opinion, of credit risk.

What is rated?

The rating services evaluate sovereign, municipal, corporate, and international bonds, and structured products. US Treasury issues are not rated on an individual basis, though the US government is rated, as are governments around the world.

What rating services don’t evaluate is market risk, or the impact that changing interest rates will have on the market price of a bond that you sell before maturity. Even the highest rated bonds and US government issues are vulnerable to loss of market value as interest rates rise or, in many cases, if the issuer or issue is downgraded.

Who uses ratings?

Individual investors use credit ratings to help make purchase decisions that are in line with their risk tolerance. In addition, they may want to check what they could reasonably expect to recover if the issuer defaulted. But before investing in any bonds, including rated bonds, investors should do their own analysis or consult with their financial advisers.

Institutional investors, such as mutual fund companies, university endowments, and pension funds, typically use ratings in conjunction with their own credit analysis to evaluate the relative credit quality of specific issues. Some institutional investors operate under guidelines that require them to purchase issues of at least a minimum credit quality.

However, the Securities and Exchange Commission (SEC) has eliminated this requirement for money market mutual funds, on the grounds that a rating should not be seen as a “seal of approval.” In a related decision, the SEC has revised, with some exceptions, the procedure for registering certain new corporate issues, eliminating a requirement that they have been rated investment grade by at least one recognized rating agency.

These moves reflect the decision by Congress to reduce reliance on credit agencies for regulatory purposes, in the wake of what many perceive as the rating agencies’ flawed assessment of mortgage-backed securities in the years leading up to the financial crisis of 2008. 

Businesses and financial institutions often use credit ratings to evaluate how much risk they would be taking by entering into a financial agreement with another firm, described as a counterparty.

In addition, issuers themselves use credit ratings to provide independent verification of their creditworthiness and the credit quality of their securities.

Rating systems

Each rating service focuses its analysis a little differently and uses a slightly different grading system. Standard & Poor’s uses ten combinations of capital letters, from AAA at the top to D for default, and indicates small variations, or notches, within categories with a plus (+) or minus (-).

Fitch’s system is similar, with the addition of an RD, or restricted default, rating to identify an issuer that has defaulted on a payment but has not declared bankruptcy or gone out of business through some other method.

Moody’s system combines capital and small letters, with Aaa as the highest rating and C as the lowest. It doesn’t assign a rating to bonds in default. The company indicates small variations, or notches, within rankings with the numbers 1, 2, and 3.

All the agencies provide detailed explanations of what each individual rating means.

In these systems, the four top grades are considered investment grade and those rated lower are considered speculative grade. Those rated C or lower are often referred to as junk bonds, or, more politely, as high-yield bonds, as the issuer must generally pay a higher rate of interest to attract buyers.

The risk of downgrading

One danger bondholders face is deterioration of the bond issuer’s financial condition. When that happens, a rating agency may downgrade, sometimes substantially, its rating of the issuer, based on how serious that financial difficulty is.

If the downgrade is from investment grade to speculative grade, the issuer is sometimes known as a fallen angel.

If downgrading occurs, implying credit risk, investors usually demand a higher yield for the existing bonds to compensate for the risk. Then the price of the bond typically falls in the secondary market. It also means that if the issuer wants to float new bonds, it may have to offer them at a higher interest rate to attract buyers.

Ratings may influence rates

Credit ratings can sometimes impact the interest rate an issuer must pay to attract investors. In bonds with the same maturity, typically the higher the bond’s rating, the lower its interest and yield. Minor upgrades and downgrades tend to result in relatively small adjustments to yield. But if a bond’s credit rating is moved up to investment grade or down to junk, there may be a big change in demand and therefore in yield.

Junk bonds

Junk bonds are the lowest-rated corporate and municipal bonds. There’s a greater-than-average risk of default. But investors may be willing to take the risk of buying these low-rated bonds because the yields are much higher than on other, higher-rated bonds. However, the prices are volatile as well, exposing investors to increased market risk.

Time is money

When bonds have the same credit risk but different terms, those with longer terms typically pay higher rates to encourage investment for an extended period, which means greater potential for inflation, interest rate, and default risk.

 

 

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