What is Bond Rating?
Bond Rating refers to the classification given to the fixed income securities by designated agencies, which helps investors to identify the future potential of the security. All aspects of the issuer’s financial standing are researched, including growth prospects and upcoming corporate actions, and only then ratings are determined. Ratings assist the investor in gauging the strength and stability of the issuer. A lower rating indicates risky investment but a higher return and vice versa.
Top Bond Rating Agencies
There are primarily 3 agencies that give credit ratings to the bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more.
- S&P Bond Rating
- Moody’s Bond Rating
- Fitch Bond Rating
These agencies work round the clock researching about the financial health of the companies and assign them ratings. All three agencies have an identical mechanism of the credit rating, of course, with slight nuances. You can refer to the Bond Rating chart below for details.
- Bonds with B level rating or above are considered to be investment grade, whereas bonds with a lower rating are considered speculative or junk bonds. These organizations endeavor to provide investors with quantitative as well as a qualitative assessment of the available bonds in the market.
- Triple-A rated bond offers more security and lower profit potential than B rated bond, also the coupon rates keep increasing as we go further down 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.read more, rating agencies usually look at the cash flow of the company, its growth rate, and its existing debt ratios. Companies with ample free 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).read more, profits, and few debt obligations are likely to achieve higher ratings.
- For government entities, similar mechanisms are employed, although the specifics may differ. The U.S. Treasury bond maintains a triple-A rating and likely always will because it is seen as extremely reliable and unlikely to default.
Additionally, the rating agency may also choose to acquire information through other supplementary sources. This may include but is not limited to reading published reports on the financial health of the company, or simply interviewing the management of the company to discuss operational performance, risk management strategies, and other important information that might assist them in understanding the complete picture.
High Yield Bonds and Rating Agencies
- These bonds are rated as below investment grade by rating agencies and include all the levels of the grade below BBB. They are also called businessman’s risk and Usually offer a high yield in the long term; however, in the shorter-term are largely volatile and can also amount to losses.
- One very peculiar class of 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.read more are called ‘Fallen AngelsFallen AngelsFallen angel bonds used to be high-rated bonds, but they've been labeled as junk bonds now. They're highly volatile and are very sensitive to the ever-changing economy.read more.’ These are a type of bonds that were categorized as investment-grade initially, but certain events led to agencies lowering their rating to below 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.read more.
- Additionally, restructurings/acquisition may heighten the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more of the issuer, to an extent where bonds become speculative. The new management may disburse high dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more and exhaust the new firms’ reserves, warranting a reduced rating of the existing bonds. In this context, a company may issue more of a speculative debt to Pay off the loans taken to finance the restructuring.
Advantages of Bond Ratings
Some of the advantages of bond rating are as follows:
- It helps investors to stay informed about the latest standing and the strength of a company.
- It assists them in decision making, with respect to selection of the right set of debt securities, and hence aids them in getting the right mix for their portfolio. For example, a risk-averse investor wants to invest only in the mix of auto and manufacturing sectors but faces budget constraints and analytical know-how. A good look at their credit ratings and reasoning may be ancillary for the investor to zero in on the right kind of instrument, thereby attaining the right set of the mix for a minimum variance portfolio.
- It asserts or rather represents a firm’s voice and body language in the market by communicating their financial standing and appealing their future prospects to investors, HNI’s, competitors, and regulators alike.
- It can be used to make comparisons between the returns and the credibility factor of two different companies.
Financial Crisis and Rating Agencies
Rating agencies were handed a lot of blame for a failure to identify the risks involved in certain types of fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more securities, especially mortgage-backed securities. The number of these ‘A’ rated bonds started to plummet in value towards the crackdown of the housing debacle. This raised some serious concerns over the credibility of the rating agencies in the investment world. Although they did not cause the crisis, they certainly had a hand in creating the bubble, which led to the crisis by reassuring the investors of the quality of Bonds that ultimately were proven to be despicable.
Numerous scholars voiced their concerns, challenging the trustworthiness of these agencies. Some were even skeptical about their business ethicsBusiness EthicsBusiness ethics is the study, application, and implementation of various principles, policies, and standards in areas such as corporate governance, whistleblowing, corporate culture, and corporate social responsibility.read more and moral code of conduct. As a result, the cloud still remains over its rating and delivery. However, an average investor does not have access to sophisticated details or sources to study the financial health of the company, which will enable him to build an impression about companies standing and future prospects in the market. As such, the only available alternative is to trust the rating agency’s assessment.
Bottom Line
Bond ratings help in knowing the credibility of the issuer. However, they being in place do not imply that due diligence is not to be undertaken before investing. Like any other security, investing in a bond is subject to market volatility, and economic cycles and the rating agencies do not have an obligation towards investors in case of miscategorized rating.
Conversely, bond ratings are a good general indicator of the relative prospects and potential of the bond and firm alike. Therefore, it is advisable for risk-averse fixed-income investors that they should carry most of their exposure in reliable bonds with good returns and, as much possible, should opt for investment-grade bonds. If one is a distressed investor or a speculator, they may turn to high risk, non-investment grade bonds for a higher return.
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