Bond ratings: Report cards for risk
If you’ve ever considered investing in bonds, it’s important to understand bond ratings, also known as credit ratings. These ratings are like report cards created by bond ratings agencies; they’re specifically designed to help investors assess the risks of investing in this asset class.
The biggest risk that bondholders face is default risk, or the likelihood that the bond issuer will be unable to make interest payments or repay the principal when the bond matures. Although default risk can never be eliminated entirely, one of the ways that investors can manage and even minimize this risk is to invest only in bonds with the highest credit ratings.
Key Points
- Bonds are fixed-income securities rated according to risk.
- Bond ratings agencies assign “grades” to individual bonds.
- The greatest risk is that a bond issuer could default on their obligations.
What is a bond?
First, a quick recap of bond market basics. When you purchase a bond, you are in essence loaning money to the entity that issued the security. This is called the principal.
In exchange for the principal, you are entitled to a series of set interest payments. Because the payments do not vary, bonds are considered a fixed-income investment. The payments are called coupon payments.
Bond market basics
Need a refresher on how bonds work and what all these terms mean? Here’s what you need to know.
All bonds have a maturity date, usually one to five years after issuance, at which time the principal is repaid to the purchaser.
There are three main types of bonds:
- Corporate bonds are issued by corporations to raise capital to fund day-to-day operations, capital improvements, and/or strategic acquisitions.
- Municipal bonds, aka “munis,” are issued by state and local governments to fund public projects such as schools, highways, and hospitals.
- Sovereign bonds are issued and backed by a national government to fund its operations. In the U.S., sovereign bonds are issued by the Department of the Treasury, so they’re called Treasury bonds. (Technically, it’s a Treasury bond if its maturity date at issuance is more than 10 years away. From one to 10 years it’s a Treasury note, and if less than one year, it’s a Treasury bill.)
Generally speaking, sovereign bonds and municipal bonds are considered less risky, while some corporate bonds have such a high risk of default that they’re called junk bonds. High-risk bonds typically offer higher interest rates in order to attract investors.
Fun fact
The first bond was reportedly issued in Mesopotamia around 2400 B.C.E. and was denominated in corn, which was the currency at the time. The first sovereign bond was issued by the Bank of England in 1694 to fund the war against France known as the Nine Years’ War.
As with any investment, you should do your homework and understand the risks. But one good thing about bonds is that there are companies—called ratings agencies—devoted to tracking bond issuers and bond risks, and assigning ratings to all sorts of bonds.
Bond ratings can help you evaluate the risk versus reward (that is, the rating versus the yield-to-maturity) on different bonds to determine which ones fit within your risk tolerance and make sense for your investment goals.
The “Big Three” bond ratings agencies
There are multiple credit ratings agencies, but only three are considered major players. Although all use similar alphabetic systems, their ratings are based upon proprietary research and analysis.
Standard & Poor’s (S&P). Founded in 1860, S&P is one of the oldest and most widely recognized credit ratings agencies. Its ratings range from AAA (the highest rating) to D (default).
Moody’s. Founded in 1900, Moody’s bond ratings range from Aaa (the highest rating) to C (default).
Fitch. Fitch could be considered the new kid on the block, as it was founded in 1913. Similar to S&P, ratings range from AAA (the highest rating) to D (default).
All three companies use plus and minus signs to indicate whether a rating is closer to the higher or lower end of the rating. In addition, there can be multiple ratings within each letter category.
Credit ratings chart, from AAA to D
Bond ratings fall into two general categories: investment grade and speculative grade. Each category contains several letter and sub-letter grades to further pinpoint an issuer’s ability to meet the financial obligations of a bond.
Each ratings agency uses slightly different language to describe each ratings category. Here’s how S&P describes each, according to its Intro to Credit Ratings (see the section “Our Ratings Scale”):
Investment grade
- AAA – Extremely strong capacity to meet financial commitments.
- AA – Very strong capacity to meet financial commitments.
- A – Strong capacity to meet financial commitments, but somewhat susceptible to economic conditions and changes in circumstances.
- BBB – Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
Speculative grade
- BB – Less vulnerable in the near term but faces major ongoing uncertainties to adverse business, financial, and economic conditions.
- B – More vulnerable to adverse business, financial, and economic conditions but currently has the capacity to meet financial commitments.
- CCC – Currently vulnerable and dependent on favorable business, financial, and economic conditions to meet financial commitments.
- CC – Highly vulnerable; default has not yet occurred, but is expected to be a virtual certainty.
- C – Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher-rated obligations.
- D – Payment default on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed.
Bonds that are rated above BBB– (or Baa for Moody’s) are considered “investment grade,” which means they have a lower risk of default. All bonds below those ratings are considered “speculative grade” and carry a higher risk of default.
Treasury bonds usually receive the highest possible credit ratings because they are backed by the “full faith and credit” of the U.S. government. Most municipal bonds (“munis”) are rated investment grade as well because they are issued by local and state governments and backed by their ability to tax and generate revenue.
Corporate bonds (those issued by both private and public companies) are rated based on the company’s debt ratio, profitability, market share, and other fundamental metrics—both current and projected—as well as macroeconomic factors. For this reason, bond ratings agencies review them regularly and will upgrade or downgrade a bond if they feel it’s warranted.
The bottom line
Although bond ratings agencies are not perfect and ratings can change over time, these “grades” provide investors with a simple and straightforward framework to evaluate risk, and more importantly, help minimize the risk of default.
The more you understand about how bonds are rated, the better you’ll be able to decide if—and which—bonds might fit within your investment objectives and risk tolerance.