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Bond Ratings Explained – Interpreting The Bond Rating System

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Introduction

 

 

 

Rating Agencies help investors assess the degree of credit risk of various bond issuers. Prime examples of Rating Agencies includes the Standard and Poor (S&P), Fitch Ratings and Moody’s Credit Survey. Ratings help the issuers determine the coupon rate and yield and in turn, help investors understand the risks that are associated with each
bond. In this lesson, bond ratings will be explained in greater detail. We will also analyze the grading systems of 3 of the most reputable rating agencies, discuss the premise of bond rating agencies, and help you determine if a particular bond investment is right for you.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

Agency Rating Systems

 

Figure 1.

 

Figure 1 shows the classification system used by the rating agencies S&P, Fitch Ratings, and Moody’s Credit Survey.

Both S&P and Fitch use the exact same rating system, with a AAA score is considered to be the highest quality bond while an Aaa is considered to be of the highest quality for Moody’s Credit Survey

Generally speaking, bonds with a BBB or Baa rating or higher are considered “investment grade” and carry less risk

All other bonds are considered ‘junk’ or high-yield bonds that carry a larger risk of not delivering interest or principal

You should know that its possible for the same bond to receive a rating that differs from one rating agency to the next. A favorable rating from a rating agency does not guarantee investment success.

Your brokerage firm can provide you with a bonds ratings. You will also want to next take a look at the rate of return before purchasing a bond.

 

What Are Bond Rating Agencies?

 

 

 

Bond rating agencies are third party organizations that rate the credit worthiness of bond issuers. Investors
use these ratings to help analyze the risk to reward aspect of a bond investment, in the way a bank analyzes whether they should loan you money.

When you borrow money from a bank, the bank checks your credit score to analyze the risks of loaning you money. Specifically, the bank is analyzing your credit risk -this is the risk that you may fail to repay the loan.

Generally, the lower the credit score, the higher the credit risk. And if you pose as a high credit risk, the banks charges you a higher interest on your loan.

A similar credit score exists in the fixed income market for corporations and governments that issue bonds. In
this case, the scores are known as credit ratings and investors can use these ratings to analyze bonds.

In the fixed income market, bonds are rated by third parties in what is otherwise known as credit agencies.

The three biggest rating agencies include Standard & Poor, Moody’s and Fitch – and these credit agencies assign credit ratings to bonds in similar ways.

Standard & Poor’s and Fitch use a system of letters with positive and negative signs (+/-). While Moody’s is a little different – incorporating numbers and letters.

These ratings are a little confusing at first, but there is a simple way to make sense of them.

Bonds with higher ratings are called “investment- grade”. Investment grade bonds have a lower credit risk, and typically as a result offer lower interest.

Bonds with lower ratings are known as ‘high-yield’ or junk. High yield bonds have a higher credit risk and, as a result typically offer higher interest.

 

A Rule Of Thumb To Follow…..

Safe investments are expected to have lower returns thus the lower coupon rate while riskier investments offer more
attractive yields to entice investors (which if you understand the market and are able to play your cards right, it can be extremely advantageous) – but it’s best that you either

1. Leave it to the professionals     OR

2. Get some outside guidance and do your research beforehand – I can not stress that enough, and don’t be shocked if the worst case scenario were to occur and you lose your initial investment.

 

These agencies assign ratings to bonds based on a number of factors.

For instance, when rating a corporate bond, the agencies analyze the company’s earnings, existing debt, and future prospects, among other factors.

When rating a government bond, the agencies analyze the country’s economic growth, tax rates, fiscal policies and more.

Rating agencies take all of these factors into account and then assign credit ratings investors can use to analyze the risk of investing in bonds.

For example, an investor can use ratings to identify bonds that align with their risk tolerance and time horizon. This means that an investor with a low-risk tolerance and short time horizon might consider investing in bonds with the highest investment grade rating. For all three rating agencies, these are all AAA rated bonds.

Conversely, an investor with a high risk tolerance and long time horizon might consider investing in lower rated bonds. These might include high yield bonds that are rated BBB or CCC.

While credit ratings provide investors with a system for analyzing risks and potential rewards in bonds, it is important to understand that agencies can make mistakes and there are times when ratings miss the mark.

The financial crisis of 2008 exposed these mistakes and rating agencies fell under heavy criticism. Agencies were criticized for failing to forecast the crisis and delaying the downgrading of certain bonds.

 

 

For example, some bond issuers maintained investment-grade credit ratings as the financial crisis unfolded, but some of these issuers ultimately went bankrupt, causing investors to lose big. The rating agencies were late to see the warning signs, or missed them altogether.

This helps investors realize that credit ratings are not always accurate. Bond ratings can be insightful, but should not be the only part of your research.

For many investors, these ratings serve as a useful starting point when analyzing the risks and potential rewards of bonds.

 

Quick Recap

In Review…..

Bond Ratings System

  • Both S&P and Fitch use the exact same rating system, with a AAA score is considered to be the highest quality bond while an Aaa is considered to be of the highest quality for Moody’s Credit Survey
  • Generally speaking, bonds with a BBB or Baa rating or higher are considered “investment grade” and carry less risk
  • All other bonds are considered ‘junk’ or high-yield bonds that carry a larger risk of not delivering interest or principal
  • You should know that its possible for the same bond to receive a rating that differs from one rating agency to the next. A favorable rating from a rating agency does not guarantee investment success
  • Your brokerage firm can provide you with a bonds ratings. You will also want to next take a look at the rate of return before purchasing a bond

 

Bond Rating Agencies

  • Bond rating agencies are third party organizations that rate the credit worthiness of bond issuers. Investors use these ratings to help analyze the risk to reward aspect of a bond investment
  • The three biggest rating agencies include Standard & Poor, Moody’s and Fitch – and these credit agencies assign credit ratings to bonds in similar ways
  • Standard & Poor’s and Fitch use a system of letters with positive and negative signs (+/-). While Moody’s is a little different incorporating numbers and letters
  • Bonds with higher ratings are called “investment- grade”. Investment grade bonds have a lower credit risk, and typically as a result offer lower interest
  • Bonds with lower ratings are known as ‘high-yield’ or junk. High yield bonds have a higher credit risk and, as a result typically offer higher interest
  • These agencies assign ratings to bonds based on a number of factors. Rating agencies take all of these factors into account and then assign credit ratings investors can use to analyze the risk of investing in bonds
  • For instance, when rating a corporate bond, the agencies analyze the company’s earnings, existing debt, and future prospects, among other factors
  • When rating a government bond, the agencies analyze the country’s economic growth, tax rates, fiscal policies and more
  • While credit ratings provide investors with a system for analyzing risks and potential rewards in bonds, it is important to understand that agencies can make mistakes and there are times when ratings miss the mark
  • This helps investors realize that credit ratings are not always accurate. Bond ratings can be insightful, but should not be the only part of your research
  • For many investors, these ratings serve as a useful starting point when analyzing the risks and potential rewards of bonds

 

 

And that’s it for this lesson here at Invest In Wall Street. You now know how to utilize bond ratings from third party rating agencies in order to make a potential investment in a particular bond. Of course, there are other factors you should consider before you make any investment.

And by the end of this lesson, you have a better understanding of what bond agencies are, how they work, and how they can serve as an integral component to your fundamental analysis of bonds and other fixed income assets.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

 

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