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Bond Ratings

© Naeem Akhtar

There are three main risks that investors face when investing in bonds: interest rate risk (the risk that interest rates could rise), purchasing power risk (the risk that inflation will rise and thereby erode the value of bonds), and credit risk (the risk that a bond issuer will become unable to meet its debt obligations). While assessing the first two risks demands that individual investors conduct a significant amount of research on their own, credit risks are arguably the easiest for investors to assess—thanks to credit ratings.

Credit ratings are essentially rankings of a company’s ability to repay their debts and to withstand various types of financial and economic stress compared to that of other companies. Ratings are intended to help provide forward-looking opinions on a company’s ability and willingness to pay interest and repay principle as scheduled. (For purposes of simplification, this article will discuss ratings as they apply to corporations. Keep in mind that the same general principles apply to government debt, municipal debt, agencies, and other fixed income securities).

The Rating Agencies There are several private companies that issue credit ratings, the most prominent of which are: Moody’s Investor Services, Standard & Poors, Fitch IBCA, and Duff & Phelps. Each of these rating agencies follows a very thorough and rigorous methodology for determining a company’s creditworthiness. While the rating that each of these agencies assigns to a particular company can sometimes vary, for the most part their assessments are not usually far apart.

The most prominent and oldest of the rating agencies is Moody’s. It all began in 1909 when founder John Moody introduced a simple grading system for railroad bonds. Soon enough, Moody’s methodology was being applied to other industries and the ratings system was underway. Moody’s current broad reach extends to roughly 1,500 issuers and some $2 trillion of bonds rated in the Aaa to Baa grades (more on these symbols later). Moody’s has ratings on 90% of public market bonds.

For anyone that can cite the alphabet, the ratings system is actually quite simple to learn. All of the rating agencies use the letters A through D to signify a decreasing level of credit worthiness.

There are two main categories of investments within the A through D grades—investment grade and below-investment-grade. Investment grade bonds are believed to have a low probability of default whereas below-investment-grade bonds are thought to have a relatively greater probability of default.

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