Bonds – one of the most fixed-income securities in the world. Their ratings are monitored closely by analysts and investors alike. But what are bond ratings exactly? How do they work? What’s a bond rating scale? We’ll explore and answer all of this and a whole lot more.
But first, let’s be clear on why understanding bond ratings is important.
Why Are Bond Ratings Important?
To some investors, bonds may seem like a bit of a boring topic.
After all, average investors don’t get rich off bonds, so why bother?
What most people don’t realise is that, with enough invested in them, bonds can be powerful cash flow tools in a portfolio.
That is, of course, as long as the bond seller is able to make good on the bond and pay the coupons and par value.
If you’re a savvy investor, you’ll likely want to know exactly what you’re investing in and whether you’re getting into a risky investment.
If you’re a beginner, you might choose to follow the wisdom of the savvy investor and learn what you’re investing in before buying bonds or any financial asset.
Whatever your experience level, understanding bond ratings is important because it will help guide you in the search for solid investments.
Now that you know why understanding bond ratings is important, let’s explore bonds in a little more detail and understand the terminology/jargon we’ll be working with.
Bonds – A Brief Overview
Let’s begin with a brief overview of bonds.
RELATED: What is a Bond?
As we highlight in our sister article on How Do Bonds Work? there are many ways of categorising bonds including by:
- interest rate (fixed vs. floating rate bonds)
- tax status (taxable vs. tax-free bonds)
- investment quality (risk-free vs junk bonds)
- time to maturity (short term vs. long term)
- risk contingencies (secured vs. unsecured)
- issuers (corporate vs. government)
If we think about one of the most popular categorisations of bonds for beginners, it’s based on the types of issuers.
Here, much like other categorisations, there’s more than one opinion on what makes up the category.
But one can think of four primary types of bonds when categorised by the issuers:
- Treasury bonds are issued from a government entity, such as the US Department of the Treasury in the US, or the RBI in India.
- Savings bonds are also issued by governments, but they are smaller amounts for individual investors.
- Municipal bonds are issued by city governments or special government entities, such as the Municipal Bonds Agency in the UK or the Canadian Imperial Bank of Commerce in Canada.
- Corporate bonds are issued by companies raising money for corporate expenditures.
These four types are based on the seller of the bond.
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The seller needs to raise money for anything from funding government budgets to a company like John Deere or AstraZeneca building a new factory.
When bonds are issued, it’s just like an individual taking out a loan – they must pay interest until the loan is repaid.
It’s important to note that, for bond issuers, bonds show on a Balance Sheet as debt (i.e., liabilities).
RELATED: What is the Accounting Equation?
The buyer of the bond collects that interest.
The rate of interest varies, but these are generally lower than 10% with many paying less than 5%.
However, the bond rating is a significant factor that helps bond issuers decide the interest rate for the bond.
Let’s get into how the bond rating figures into the bond value.
What Are Bond Ratings?
A bond rating is similar to a credit score – it is a way for investors to know the creditworthiness of a company and the likelihood that they will pay back their debts.
In other words, it can be seen to represent the risk of the bond.
A higher rating means that the company has a strong capacity to repay debts while a low rating may represent a company that could have difficulty repaying its debts.
What Is The Bond Rating Scale?
The rating scale for a credit score is typically a three-digit number, but the bond rating scale is usually a letter-based scale.
There are several companies that review and rate a bond, and the scales each one uses are mostly similar.
We’ll dig more into the credit rating agencies later.
Bonds are separated into two main tiers:
- “investment-grade” bonds
- “non-investment grade” bonds
Investment-grade bonds are those that are issued by companies that have the highest likelihood to repay debts.
For instance, here are the ratings given to those bonds:
Investment Grade Ratings
|Standard & Poor’s||Fitch|
The rating system makes a bit more sense when you can compare the system of each rating agency and understand that they are all very similar.
Generally speaking, AAA is almost always reserved for risk-free securities. Or at the very least, assets that are very close to the risk-free asset.
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Very simply, more letters mean a higher rating, and the plus and minus signs speak for themselves.
The other tier is known as “non-investment grade,” or sometimes “junk bond.”
These are bonds that come with significant long-term risks and sometimes even significant short-term risks for companies on the verge of default.
The ratings for non-investment grade bonds can be seen here:
Non-Investment Grade Ratings
|Standard & Poor’s||Fitch|
How Are Bonds Rated?
Some in the industry might say that rating bonds is an art as well as a science.
It involves mathematical analysis, true, but there are external factors that come into play.
At the top level, rating a bond is very similar to how a credit scoring agency will give you a credit score.
Ratings agencies will look at the balance sheets and expectations of revenues for the seller of a bond, and this can be elusive at times.
Let’s compare how a rating agency considers revenue expectations for a corporation looking to issue corporate bonds and a city looking to issue municipal bonds.
Obviously, a corporation depends on revenues from sales, but determining the future expectations of revenue tends to be far more difficult.
This is where the art of bond rating comes into play.
Alternatively, a municipal bond comes from a city that collects taxes from residents and companies.
If more people and companies move to that city, the city is likely to collect more taxes.
If people and companies move away from the city, they might expect tax revenues to drop, and debt repayment becomes less likely.
Ratings agencies must also take external information into account.
Specifically, they must look into the risks of things like interest rates increasing in the near future and consider how much this will impact the bond issuer.
What is the Purpose of the Bond Rating System
The bond rating system helps not only average retail investors to decide where to place their money but also the massive investment firms like Vanguard or Fidelity.
Much of the investment world is driven by analysis, whether human or computer, so the bond rating system helps in several ways.
The most obvious is that it provides a simple way for all investors to know how risky a bond is before buying it.
Another way the rating system is helpful is that it allows large investment firms to package bond funds with a very specific risk profile in mind.
They can create bond-only mutual funds packaged with only the highest-rated bonds included for risk-averse clients or they can include a few bonds from riskier companies that may pay a bit more interest.
Either way, bond fund managers have the ability to use the rating system to package funds with a high degree of accuracy.
Bond and Credit Rating Agencies
The terms “bond rating agency” and “credit rating agency” can be interchangeable since they refer to the same principle of rating a company’s creditworthiness.
These and others who operate in the US are required to register with the SEC, though international entities may have different requirements.
While they came under scrutiny around the 2008 Financial Crisis, it’s important to point out that the rating of not only bonds but other securities is critical to the industry by keeping investment firms accountable to risk standards and keeping fees lower for average investors.
Ratings agencies will issue a rating at the time of a bond’s issue, though they are always re-evaluating ratings and submitting updated ratings depending on current events which may affect the bond and its issuer.
Risk and Reward – How To View Bond Ratings
We’ve been talking about interest rates, also known as the bond yield, paid to buyers of bonds like you and me.
Let’s get a little more into how the bond rating affects returns.
It’s easy to use the metaphor of your personal credit rating because it works somewhat the same.
When you have a low score, you have to pay higher interest for loans and credit cards because a bank deems you a higher risk.
The same goes for bond ratings.
When a company has a low bond rating, it means there is a higher likelihood of the company defaulting on loans.
Because of this, a riskier company needs to entice would-be bond buyers like you and me with higher yields – higher “rewards” – to make sure they can raise the money they need.
Alternatively, a higher rating results in a lower yield because there is little worry about the company paying back the debt.
Final Thoughts: What Are Bond Ratings?
Bond ratings serve an important function in today’s financial world.
They provide a simple measure of how risky a bond is while also allowing large investment firms some flexibility in creating managed bond funds.
Even though bonds pay lower returns, it’s important to understand the risks involved when you may need the cash flow of bonds in retirement.
The bond ratings are there to help you navigate those risks.
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