Understanding Bond Ratings

Three major organisations, Standard and Poors, Moodys and Fitch issue bond ratings. Their ratings are a shorthand assessment of the ability of a corporation or government institution to pay its debts. As will be explained this information is useful for all those who invest in bonds and other debt securities.

First it is necessary to understand some of the basic points about bonds. A bond is a tradable loan. The issuing body arranges to borrow money at a prescribed interest rate which is paid at regular intervals to the lender until the loan is paid off, or the bond reaches maturity and the remaining loan is paid back. When the bond is traded the new owner becomes entitled to the interest payments.

When an institution or bank lends money it determines the interest rate from two considerations. It takes into account the prevailing interest rate in the market, such as the bank rate, and adds a risk premium to take into account the riskiness of the loan.

The riskiness of the loan takes into account the probability that the borrower might default and not pay back the loan. As a general rule in business the higher the risk the higher the reward.

The three bond rating agencies, Standard and Poors’, Moodys and Fitch have developed to fulfill a need to assess the riskiness of a loan or bond placement. The three agencies have in house methods which assess in detail the financial strength of corporations, national and local government institutions. They assess the capital strength, solvency, liquidity, earnings and business position of each entity to determine its financial stability.  When the analysis is complete the rating agency ascribes a letter between AAA and D to describe the financial strength of the entity. The lender usually pays for the analysis because without it it would be very difficult to find a bank or institution prepared to issue a bond. Modern practice has become so stringent that many institutions now demand credit ratings from all three agencies before a bond is issued.

Generally Governments are considered to have strong revenue raising powers and maintain strong credit ratings. The position with corporate bonds is often quite different. The credit rating score issues by a bond agency directly influences the availability and price of debt. A corporation which has an A, AA or AAA grade is financially well capitalised and is in the best place to raise finance and issue debt. Corporations that have a credit rating of BBB- or below are seen as financially vulnerable and have restricted access to debt finance at a higher cost. The term junk bond is used in the financial literature to describe a bond with a Standard and Poor’s grading of BBB- or below. The C grades indicate that a corporation is in such poor financial health that a default, or on payment of interest when it is due is almost inevitable. If a default had already taken place the bond rating agencies assign a D category. Although the A,B,C,D system is used publicly the rating agencies publish tables which relate the letters to actual default rates. This enables the issuing institution to accurately price the risk.

Having issued an initial rating the bond agencies undertake regular reviews of the rating, usually when new financial information becomes available. The ratings are sensitive because they directly influence the ability of a company to raise debt finance. The rating agencies are therefore reluctant to make sudden changes to their ratings. An indication of a potential change is usually preceded by a press notification that a bond rating is on watch pending an up or down change. When changes occur they are usually by only one rating grade at a time. However, be warned the rating agency are sometimes so cautious to change ratings that market events can overtake them.

Rating agencies have become a very influential measure of corporate and government financial strength. They directly influence the ability of a company to raise debt. A change in a corporate bond rating can cause price changes to the corporate share price as well as changes to the value of corporate bonds.

An investor who monitors bond ratings is given an early warning that a bond might default. The bond rating helps the investor manage his default risk.