Bond Rating Definition
A bond rating evaluates a bond based on the issuers’ financial health to ensure investors of timely payment and guaranteed repayment. There are agencies that provide ratings to the corporate or government bonds to indicate how fruitful it would be to invest in the bonds in question. Based on these ratings, the investors decide whether to make an investment.
The concerned agencies assess and thoroughly research the financial strength, stability, and performance, along with various other factors to check how worthy the firms issuing the bonds are of investors’ trust. Finally, they assign the ratings to bonds in an alpha-numeric format.
Table of contents
- Bond rating refers to the rating system for the bonds offered by firms or government institutions, assessed for their creditworthiness.
- When found financially stable, the bonds issued by those entities acquire higher ratings and vice-versa.
- Standard & Poor’s (S&P), Moody’s, and Fitch are among the top Nationally Recognized Statistical Rating Organizations (NRSRO) accredited by the United States Securities and Exchange Commission (SEC).
- Though it helps investors and bond-issuing firms in various ways, a bond rating is not always free of flaws.
How does the Bond Rating System Work?
A bond rating system helps individuals and firms make smart and well-informed investment decisions. The professional financial analystsFinancial AnalystsA financial analyst analyses a project or a company with the primary objective to advise the management/clients about viable investment decisions. They do a thorough financial analysis and make suitable objective projections to arrive at their conclusions. provide the alpha-numeric ratings based on which the investors identify the fruitful and junk bonds. As a result, they prefer investing in bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. of the issuers who can pay the interest timely and the complete amount when the bond matures.
The rating agencies explore every perspective of a firm or institution issuing bonds to check if they are in a sound financial position to pay the interest and principal on time. Then, based on their assessment of their creditworthiness, they provide ratings to the bonds, depending on which investors make an investment decision. While bonds with higher ratings are considered investment-grade bonds, the rest are categorized as high-yield bondsHigh-Yield BondsHigh yield bonds are bonds that pay higher interest than others but are assigned lower credit ratings by popular credit rating agencies. Ratings below “BBB” from Standard & Poor and below “Baa” from Moody’s are due to additional credit risks involved in interest and principal repayment. or junk bonds.
Bond Rating Agencies
The rating agencies have professional analysts to analyze how fruitful or risky it would be for an investor to invest in a particular bond. These agencies apply different parameters to assess the quality of the bond through a bond rating chart. This chart helps investors to distinguish between the ratings that each agency provides. Based on their level of understanding and analysis, the investors decide if they should proceed with a bond investment or look for other alternatives.
Standard & Poor’s (S&P), Moody’s, and Fitch are the top Nationally Recognized Statistical Rating Organizations (NRSRO) that investors look up to for reliable ratings. These entities evaluate different factors to assess the financial health of every bond issuerBond IssuerBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures., be it a corporation, an individual, or the government itself. Based on the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan. of the entities that issue these bonds, the agencies provide valid ratings to them.
On the bond rating scale, it arranges the bonds to help investors identify and understand which deal would be fruitful or risky to spend in. First, the agencies prepare a bond rating chart displayed to investors. Based on their evaluation, they rate the bonds on the chart. As a result, investors can have a consolidated view of the ratings provided by different agencies for the same bond. This, in turn, helps them compare the credit quality of the corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value. or government bondsGovernment BondsA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income., whichever they want to opt for.
Though all the three bond rating agencies consider different factors to assess the credit quality of the bonds, their mechanism and rating system are quite similar. For example, if an S&P and Fitch bond rating for a particular debt security is BBB- and a Moody’s bond rating for the same is Baa3, the bond is an investment-grade bond involving lower risk. On the contrary, if rated lower on the respective scales, it becomes a non-investment grade bond.
- Bonds with a B-level rating or above are considered investment gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments., whereas bonds with a lower rating are considered speculative or junk bonds.
- Triple-A rated bond offers more security and lower profit potential than B-rated bond. In addition, the coupon rates keep increasing as the rating move down, thereby intending to compensate for the risk offered.
- In the case of a corporate bondCorporate BondCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value., rating agencies usually look at the cash flowCash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX). of the company, its growth rate, and its existing debt ratiosDebt RatiosThe debt ratio is the division of total debt liabilities to the company's total assets. It represents a company's ability to hold and be in a position to repay the debt if necessary on an urgent basis. Formula = total liabilities/total assets. Companies with ample free cash flowFree Cash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX)., profits, and few debt obligations will likely achieve higher ratings.
- The administrative authorities employ similar mechanisms for government entities. The specifications may differ, though. The US Treasury bondTreasury BondA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company. maintains a triple-A rating and likely always will because it is extremely reliable and unlikely to default.
Rating the bonds helps investors make informed decisions and enables bond issuers to build their market reputation. When a rating agency gives a better rating to a bond, the issuer is considered financially stable. As a result, the issuing entity becomes trustworthy so far as obtaining credits is concerned. In short, it becomes easier for them to borrow money for business growth and other requirements from different financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. .
In addition to the above, there are multiple other benefits of rating bonds:
- Bond rating helps investors stay informed about the latest standing and the strength of a company. As a result, they make well-informed investment decisions.
- It lets them select the right set of debt securities. Hence, the investors get an opportunity to have the right mix for their portfolios.
- Rating a bond helps firms approach the market players, indicating their financial standing. Through the ratings, they appeal to their prospects to investors, high-net-worth individuals (HNWIs), competitors, regulators, etc.
- Investors use the rating chart to compare the returns and credibility of two different companies and the bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. they issue.
Let us consider the following bond rating examples to understand the concept better:
Company A issued a corporate bond to raise funds for its business after a major setback. S&P, Fitch, and Moody’s rated the bond as AA+, AA, and Aa3, respectively, given the long-built market reputation of the firm. Investors witnessed the investment-grade ratings that the bond received, and hence, most of them decided to invest in it.
In 2008, the debt securities with Triple-A rating in the prior year witnessed a huge downfall, with Moody’s downgrading them to 83% of $869 billion mortgage-based securitiesMortgage-based SecuritiesA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.. Thus, the ones with the highest ratings became the junk bonds of 2008.
In this scenario, the agencies couldn’t predict what would happen in the future. As a result, investors who expected a fruitful return on the investment felt trapped.
A bond rating chart is not free of flaws. Different rating agencies evaluate different factors to rate the bonds. However, in the process, there are chances of missing out on points that might take a bond’s rating either up or down.
The bond-issuing entities pay the rating agencies to feature their bonds and make them reachable to investors via different media. As a result, there might be a conflict of interest, which the investors must consider before blindly trusting the results.
Moreover, the rating system for bonds does not foresee the upcoming scenarios. This, in turn, might turn a deal negative for investors in the event of any unusual market turmoil.
Frequently Asked Questions (FAQs)
Bond ratings are an arrangement using which the bonds issued by government institutions or corporate firms are rated, depending on how financially capable the entities issuing them are to pay the interests and principal amount on time. These ratings, of course, help investors make well-informed investment decisions and let the bond-issuing entities strengthen their market reputation if rated higher.
The ratings are calculated based on the parameters that respective rating agencies take into account. Normally, the rating agencies look at the cash flow of the company, its growth rate, and its existing debt ratios. Hence, the firms and institutions with ample free cash flow, profits, and few debt obligations are expected to achieve higher ratings than the rest.
The bonds receive a rating from the rating agencies. The financial analysts consider different factors to assess the bond-issuing entities’ creditworthiness and rate the bonds accordingly. Standard & Poor’s (S&P), Moody’s, and Fitch are among the top SEC-accredited Nationally Recognized Statistical Rating Organizations (NRSRO).
This is a guide to Bond Rating, its definition, and examples. Here we explain how agencies like Fitch, Moody’s & S&P prepare the rating chart. You can learn more about accounting from the following articles –