Bond ratings are an approach to assess the creditworthiness of the bond, which relates to what it costs to borrow for the issuer. The ratings usually provide a "Letter Grade" to bonds, which indicates their creditworthiness. Private rating companies like Standard & Poor's, Fitch Ratings Inc. and Moody's Investors Service evaluate the financial strength of a bond issuer and their ability to payback a bond's interest and principal in timely manner.
How Do Bond Ratings Work?
Rating agencies analyze the financial condition of every bond issuer (including municipal bond issuers) and give a rating to the bonds offered. Each agency follows a system to aid investors in assessing the bond's creditworthiness compared to different bonds.
Moody's, Fitch, and Standard & Poor's add their ratings to an indicator to indicate the bond's position in a specific category. Moody employs an indicator that is numerical. A1, for instance, is superior to A2 (but isn't as great compared to Aa3). Standard & Poor's and Fitch employ an indicator of minus or plus. For instance, A+ is better than A, and A is superior to A-.
Remember that ratings aren't 100% accurate and cannot inform you if your investment increases or decrease. Before using them as an aspect of your investment selection process, be aware of the methodology and the criteria every agency uses. Some methods may prove to be more effective than others.
Breaking Down Bond Rating
Most bonds are rated by at minimum one of the three major independent rating agencies:
- Standard & Poor's
- Moody's Investors Service
- Fitch Ratings Inc
From U.S. Treasuries to international corporations, these organizations conduct an exhaustive financial analysis of the bond's issuer. Based on their own set of guidelines, they determine the company's ability to pay its bills and be liquid and consider a bond's outlook and future expectations. The agencies announced the bond's overall rating by compiling these information points.
S&P Global Bond Ratings
S&P is the longest-running credit rating company and one of three NRSROs recognized by the U.S. Securities and Exchange Commission. The company has over 1 million credit ratings on corporate and government bonds, structured finance companies, and securities. S&P offers both long-term and quick-term ratings for bonds. The primary objective of rating the S&P credit score is to evaluate the probability of default on security.
Moody's Investors Service Bond Ratings
Moody's is a different Rating agency that focuses on credit ratings and bonds that NRSRO accredits. The agency has more than 135 sovereign states and 5,000 corporate issuers that are not financial, as well as 4,000 financial institutions, 18000 public-sector finance companies, 11,000 structured financial transactions, and 1,000 project and infrastructure finance issuers. Contrary to S&P and Fitch, the main purpose that drives Moody's ratings is the assessment of losses anticipated in the event of default. The numerical modifiers are placed in the existing rating categories ranging from Aa to Caa. The number 1 signifies it is in the upper end of the rating category. 2 indicates an intermediate rating, and 3 is the lowest end of the rating category.
Fitch Ratings
It covers a variety of industries, such as insurance companies, financial institutions, sovereigns, corporate finance, sovereigns, organized finance, Islamic finance, and global infrastructure. But Fitch's market share is small compared to the market share of its larger competitors. Like S&P, its primary reason for Fitch's ratings is to assess the default probability of security. Fitch also utilizes an index of bond ratings similar to the one used by S&P.
2008 Downturn
Many Wall Street watchers believe that the independent rating agencies for bonds played a key role in contributing to the 2008 recession. It was brought to it to be discovered that during the time leading up to the financial crisis, rating agencies were paid to offer falsely high ratings for bonds and, in the process, overvalued their value. A prime example of this fraud technique was in 2008 when Moody's dropped 83% out of the $869 billion mortgage-backed securities that were rated "AAA" just the previous year.
In short, long-term investors should have most of their exposure to bonds in stable, income-producing bonds that come with the investment grade bond rating. Investors with distressed and speculative backgrounds who make a living from high-risk, high-reward investments might want to look into switching to non-investment quality bonds.
