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.
Types of Bond Ratings
There are primarily 3 agencies that give credit ratings to the bond.
- 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 bond, rating agencies usually look at the cash flow of the company, its growth rate, and its existing debt ratios. Companies with ample free cash flow, 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 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 shorter term are largely volatile and can also amount to losses.
- One very peculiar class of high yield bonds are called ‘Fallen Angels’. 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 grade.
- Additionally, restructurings/acquisition may heighten the credit risk of the issuer, to an extent where bonds become speculative. The new management may disburse high dividends, 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
- 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 mix for a minimum variance portfolio.
- It asserts or rather represents a firms 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 income securities, especially mortgage-backed securities. The number of these ‘A’ rated bonds started to plummet in value towards the crackdown of 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 ethics 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 rating agencies assessment.
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.
This has been a guide to what is Bond Rating and its definition. Here we discuss the top bond rating agencies S&P, Moody’s, and Fitch along with detailed explanations of how it works. You can learn more about accounting from following articles –