Understanding Bond Credit Ratings

By Michael Diaz. May 7th 2016

If you have dabbled in the municipal or corporate bond markets, then you might have noticed that many corporate and municipal bonds have credit ratings attached to them. But what do these credit ratings mean and why are they important to investors? Before buying any type of bond, you should have a solid understanding of what credit ratings are, what they tell you and how they affect bond yields.

What Are Bond Credit Ratings?

Most public corporate and municipal debt have a credit rating attached to it. The purpose of the bond credit rating is to let potential investors know the creditworthiness of the company or municipality that issued the bond. Specifically, a bond’s credit rating is a measure of the likelihood that the bond issuer will repay the bondholder when the bond becomes due. The higher the credit rating, the higher the chance that the bond issuer will repay the bondholder.

Large companies with solid financial profiles and strong business trends tend to have higher credit ratings than smaller companies with less stable finances or limited operating history. Similarly, large municipalities that have significant taxing power, a disciplined financial strategy, significant cash reserves and a modest amount of debt tend to have higher credit ratings than smaller less disciplined municipalities.

Who Are The Raters?

In the United States, there are three major companies that issue bond ratings. These are: Moody’s, Standard And Poor’s, and Fitch.

What Is The Rating Scale?

Each rating agency has a scale of long term and short term credit ratings. Short term ratings are for bonds that mature in a year or less. Long term ratings are given to longer term bonds. Long term ratings are broken down into investment grade ratings and non-investment grade ratings (non-investment grade ratings are also known as high yield ratings). Short term ratings are typically only for investment grade bond issuers.

Investment grade ratings are given to bond issuers that have a relatively lower risk of being unable to pay their bondholders. Non-investment grade or high yield ratings are reserved for those bond issuers that have a relatively higher probability of being unable to pay their bondholders.

The highest long term credit rating is the AAA/Aaa rating. The lowest long term investment grade rating is Baa3/BBB-. All long term ratings below this level are considered non-investment grade. The highest short term rating is P-1/A-1+/F1+. The lowest short term rating is P-3/A-3/F3. Here are the long and short term rating scales used by the three major rating agencies.

Investment Grade

Long Term Ratings

Moody's

S&P

Fitch

Aaa

AAA

AAA

Aa1

AA+

AA+

Aa2

AA

AA

Aa3

AA-

AA-

A1

A+

A+

A2

A

A

A3

A-

A-

Baa1

BBB+

BBB+

Baa2

BBB

BBB

Baa3

BBB-

BBB-

High Yield

Ba1

BB+

BB+

Ba2

BB

BB

Ba3

BB-

BB-

B1

B+

B+

B2

B

B

B3

B-

B-

Caa1

CCC+

CCC+

Caa2

CCC

CCC

Caa3

CCC-

CCC-

 

Investment Grade

Short Term Ratings

Moody’s

S&P

Fitch

P-1

A-1+

F1+

P-1

A-1

F1

P-2

A-2

F2

P-3

A-3

F3

Ratings Change

Since the financial wellbeing of companies and municipalities can change, so can the credit rating on their bonds. The rating agencies keep up to speed on the companies that they rate. If they believe that a company or municipality has experienced a reduction in credit quality, they might lower or downgrade the credit rating. Similarly, improvements in financial and business performance are often met with credit rating upgrades. The bottom line is that you should track the credit rating changes of bonds that you own. A slew of rating downgrades could mean that the bond issuer is about to go bankrupt.

Why A Bond’s Credit Rating Is Important

It’s A Proxy For The Risk Of The Bond: If you are thinking about buying a certain bond, the credit rating will help you determine how risky the investment is. However, it is important not to rely solely on the credit rating to assess the risk of the bond because the credit agencies make mistakes and are sometimes slow to react to changes in a company’s financial health. Therefore, you should also do your own research on the financial health of the company or municipality before purchasing a bond.

It Determines The Interest Rate Paid On The Bond: The higher the credit rating, the lower the interest you will receive on a bond. The lower the credit rating, the more interest you will be paid. You receive more interest on lower rated bonds because they are perceived as risker than higher rated bonds. Because you face a higher risk of not getting your money back, the interest you receive will be greater.

It Is A Decent Approximation Of The Financial Health Of A Company Or Municipality: Before giving a company or municipality a credit rating, the credit agencies thoroughly investigate the company’s financial and business profile. Therefore, the rating serves as a rough approximation of the company’s financial and business health.

Now that you know what bond credit ratings are, you will have a better sense of the differing risks associated with different bonds. Fully understanding the risks of any investment product is crucial to obtaining a successful investment strategy. Do your homework ahead of time and it will pay off down the road.

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