Bond Ratings

Some investors mistakenly believe that all bonds are the same.  That is simply not true, and bond ratings were specifically developed to help investors understand the relative risk involved with the purchase of various bonds.  Except for federally-issued bonds, all bonds carry a potential risk of default.  Bond ratings enable the investor to evaluate, and balance, the risk of default with the interest payments paid on the bond.

Buying Bonds and Risk of Default

Buying bonds is mistakenly thought to be a relatively safe investment.  After all, the interest expense on a bond is paid before any dividends are paid to stockholders.  In fact, unless a company is prepared to declare bankruptcy, the chance of non-payment on a bond is very small.  Unfortunately, as small as that risk might be, there are companies that do go into default on their bonds.  The risk of default is not only possible, it is also very real.

When that happens, the bondholder not only doesn't get paid their interest payment, but they're also at risk of losing the money they have invested in the bond itself.  Keep in mind that some bonds are issued with maturities of ten years or more.  In this fast-paced economy, the business model of many companies can change pretty dramatically over ten years.

Risk of Default and Bond Ratings

Perhaps the single most important value of bond ratings to investors is the independent assessment of the bond's risk.  Bond ratings are a third party's assessment of the issuer's ability to make all of their future financial commitments to bondholders.

As new information becomes available, this can change a company's financial stability or earnings outlook.  The bond, or credit rating, of the company will change to reflect this new information.

Bond Quality Ratings

When you hear a report about a company's bond ratings in the news, you are really listening to information about the credit quality of the issuer.  When a company has a poor bond rating, they present a credit risk to the bond market, banks, and / or investors.  As an investor, you can lend the company money by purchasing their bonds.  As a creditor of that same company, you are assuming a risk of repayment or nonpayment.

Bond / Credit Rating Agencies

Currently, there are three credit agencies that set the standards for bond quality ratings:  Moody's, Standard and Poor's, and Fitch Ratings.  To make matters a little more complicated, each agency has a slightly different bond rating system.  Fortunately, these differences also work to the investor's advantage because all three bond rating agencies issue an alert when they are considering a change in a company's bond rating.

That means the investor has access to a lot of information about a company's credit risk from several points of view.  For Moody's, this alert system is termed Under Review.  For S&P it's called CreditWatch, and Fitch simply calls it Rating Watch.  These terms are used to alert investors to a possible, or pending, change in a company's bond rating.

Bond Rating Credit Codes

There are roughly ten different credit ratings, or grades, that each agency publishes.  The ratings range from Investment Grade to In Default.  In addition, each company offers refinements, or additional granularity, to these codes such as a plus or minus sign to indicate direction or relative standing within a particular rating category.  The following bond rating table shows the relative rating system for all three bond rating agencies:

Bond Rating Grades

Note to Bond Rating Table:  Moody's uses a modifier of 1, 2, or 3 to show relative standing in a category.  Standard and Poor's and Fitch Ratings use a modifier of plus or minus.

Bond Rating Example

Here are several quick examples that help bondholders to understand how to read these bond ratings, and understand how the refinements work:

• If a company is carrying a credit rating from Standard and Poor's of BBB-, then it is of lower quality than a company carrying a credit rating of BBB.   Using this same example, a company with a credit rating of BBB+ is of higher quality than BBB.
• A company carrying a credit rating from Standard and Poor's of BBB is of similar credit quality to a company carrying a credit rating of Baa from Moody's.
• Bonds carrying a credit rating of Ba or BB and lower are not considered investment grade.  Bonds with ratings of Baa or BBB and higher are considered investment grade.

Bond Ratings Affect Profits

The impact of credit ratings on a company's ability to raise capital can be enormous.  Some of these changes might sound like subtle differences, but to companies looking to borrow money on the market, each little movement adds to, or lowers, their cost of borrowing in terms of interest rates and interest expense.

When a company's credit rating is lowered, it is more expensive for that company to borrow money due to higher interest expense payable on the bonds.  In turn, these higher expenses result in lower earnings per share, or a lowering of the company's overall profitability.

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