Understanding Bond Ratings and How It Works

Understanding Bond Ratings and How It Works

A bond is a financial agreement made to, however, an investor by a company or the government. This guarantee states that a bond issuer would make periodic interest payments and eventually return an investor’s primary investment to generate profit. This guarantee, however, is only as good as the bond issuer’s financial status.

Despite this assurance, some bond issuers fail to fulfill their demands, causing shareholders to lose income. This brings us to how Bonds are Rated and why ratings are one way to evaluate the likelihood that a bond issuer will fulfill its financial commitments.

The Body That Determines How Bonds are Rated

Third-party assessment firms decide ratings to help keep bond evaluations impartial and independent. Although the general categories are supposed to be identical, the three major rating agencies Fitch, Standard & Poor’s, and Moody’s, give contrasting ratings to bonds.

These institutions are not law enforcement agencies, rather they are for making a profit for companies in their own right. Bond ratings are assigned by Moody’s, Standard & Poor’s, and Fitch in exchange for cash payments, which is one of the ways corporations make money for their stockholders.

The Bond Rating Scale

The liquidity position of the underlying company is used by rating agencies to assign ratings to a company’s bonds. In essence, bonds are given ratings ranging from AAA to D, with AAA-rated bonds indicating the most financially sound corporations.

Ratings can be changed within all of these classes by using + and – symbols, such as “BBB+” or “AA-.”

What The Ratings Imply

“Investment-grade” ratings are the top four ratings in each classification system. Bonds rated AAA, AA, A, or BBB under Standard & Poor’s rating system, for example, would be considered “investment grade.” Investment-grade bonds are regarded as the most likely to meet their debt commitments without difficulty. Only investment-grade bonds are available to some investors, such as banks, insurance companies, and mutual funds.

Bonds with a rating below investment grade are regarded as speculative. Bonds with a rating of CCC or worse were often referred to as “junk” bonds, and while that name remains, these bonds are more commonly referred to as “high yield.”

An investor must be prepared to forfeit both interest and initial fees when investing in high-yield bonds. Lower-rated bonds should therefore be left to skilled traders or, at the very least, mutual fund managers who can spread the risk for individual investors. Of course, high risk comes with tremendous profit, which is why some investors are interested in this asset class.

Rating Influencers

Anything that increases a bond issuer’s financial solvency has the potential to raise its rating, whereas anything that lowers its solvency could result in a rating downgrade. Increasing business profits, for example, allows a corporation to satisfy its debt commitments with more financial flexibility. Existing debt can be retired or refinanced at a lower interest rate, which can improve a company’s financial standing and lead to an upgrade.

Mistakes in finance, such as overspending on a new building or investing in a low-performing market segment, can deplete a company’s cash flow and increase its debt-to-equity ratio. This makes a company less likely to pay its interest, which could lead to a downgrade in its credit rating.

Bond Insurance and How It Works

Bond insurance safeguards investors against a bond default. The bond insurer covers if an issuing company files for bankruptcy or is otherwise unable to make interest and principal payments, similar to how you can buy insurance to safeguard your property in the event of loss or damage.

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Corporate effects are usually uninsured and stand on their own, while municipal bonds, on the other hand, are frequently insured. Insurance raises a bond’s rating to AAA, regardless of the issuing entity’s underlying financials. This is because if the issuing bank breaches the contract, the bond will be paid off by the insurance firm that provided the coverage.

Additional insurance is frequently paid for by municipalities to make a bond offering more desirable to investors. Whilst the publicly listed corporation’s financial position must be reported, municipalities can be more difficult to evaluate for investors, nonetheless, bond insurance helps to reduce some of this anxiety by adding a layer of protection.

Ratings Shift Over Time

A bond rating isn’t a one-time evaluation that follows a bond throughout its life. Some bonds have ten-year, twenty-year, or even thirty-year maturities. The financial circumstances of the foundational entities are bound to change over such extended periods, for good or bad turns.

Agencies carefully monitor bond issuers’ financial statements after approving a preliminary rating. A downgrade may be issued if a bond issuer runs into financial difficulties and is less inclined to make bond payments. Equally, if a company improves its financial situation and becomes more financially stable, its bonds may be upgraded.

A rank raise for bond issuers means that they will be able to issue new debt with the enhanced rating. Bonds with a higher rating pay lower interest rates, thus a firm or government organization can save money on interest payments. These new notes can be used to fund growth prospects at a reduced interest rate or to pay down existing bonds with higher interest rates.

For instance, say a company with BBB rating issues a bond with a 6% interest rate initially, if the company receives an upgrade to A, all other factors being uniform, they may be willing to issue a bond with a 5% interest rate. A single percentage point of interest on a $10 million bond issue equates to a 1% return.

From the standpoint of an investor, a rating upgrade is beneficial since higher-rated bonds are more in demand, resulting in price increases. Consider two CCC-rated bonds that pay the same 6% annual interest rate. If one of those bonds were upgraded to BBB, investors would flock to it because it is perceived as being more secure in the opinion of the rating agencies; in other words, the higher-rated bond is more inclined to pay interest and principal, making it more marketable.

When investors buy more of a bond, the price rises until it resembles the yield of other bonds with the same grade. Even though the stated interest rate would stay unchanged,

Bond Defaults and Ratings

A bond rating’s worth is determined by its capacity to prevent investors from losing money in the event of a default. While there can be no guarantees that anyone’s bond will continue to be viable, the lower the rating, the more likely default is.

Fortunately, bond defaults are still uncommon in general. Only 20 defaults of US public finance bonds were reported by Standard & Poors in 2017. Eighteen of the bonds were non-housing bonds that were ranked beneath investment grade at the time of default, and two were housing bonds that were rated B-.

The Use of Bond Ratings

Bond ratings are intended to indicate a bond issuer’s financial strength. However, the fact that they exist does not negate the need for investors to conduct due diligence when evaluating a potential investment. As the 2008 financial crisis demonstrated, rating agencies have no legal obligation to investors if they misclassify a bond that later defaults. However, ratings, particularly those rated triple-A, provide a strong general indication of a bond’s relative safety.

The Author

Ajisebutu Doyinsola

Doyinsola Ajisebutu is a journalist, mother, and prolific writer who takes a special interest in finance, insurance, lifestyle, parenting, business, and the Tech world.