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Bond Ratings

Credit rating agencies like Moody's and Standard & Poor's rate the creditworthiness of bond issuers on scales like AAA to D. Higher ratings mean lower borrowing costs but also lower yields. Ratings below BBB are considered "junk" or non-investment grade, and some institutional investors cannot hold them. Individuals and companies should pay attention to ratings because they influence borrowing costs and the ability to attract customers or make investments.

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106 views2 pages

Bond Ratings

Credit rating agencies like Moody's and Standard & Poor's rate the creditworthiness of bond issuers on scales like AAA to D. Higher ratings mean lower borrowing costs but also lower yields. Ratings below BBB are considered "junk" or non-investment grade, and some institutional investors cannot hold them. Individuals and companies should pay attention to ratings because they influence borrowing costs and the ability to attract customers or make investments.

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BOND RATINGS

(adapted from http://beginnersinvest.about.com,)

Credit worthiness is rated by credit-rating agencies dominated by two giants, Moody’s and
Standard & Poor’s, with a distant third, Fitch Investors Service. In effect, these companies
rank others based on their chances of defaulting. Note that default does not necessarily
mean failing to pay the full interest on the debt, but rather the potential for delays in
payment. Once again, I am trying to stress that in valuing assets not only the amount and risk
of cash-flows are important, but their timing -when you actually receive the promised cash
flows - play a major role in determining their value.

The highest quality rating is AAA, followed by AA, and so on. Rating below BBB is
referred to as non-investment quality or junk bonds, where non-investment means that
certain institutional investors are not allowed by law to invest in these bonds.

Note that U.S. government bonds are not rated as they are considered default free. Moreover,
these agencies rate debt issued by corporations as well as munis - those issued by states,
counties and municipalities.

Q So why should companies care about how their credit is rated?

A There are two disadvantages of lowered ratings:

(1) The lower the rating, the higher the cost of borrowing. Thus, the lower the
company’s value.

(2) The lowering of rating might make the bonds less liquid in the secondary
market. This would also increase the bond’s YTM (i.e., the required return on
the bonds), thus increasing the cost of borrowing for the firm.

Q Should individuals who have no intention of buying any of these companies’ bonds care
about the ratings?

A Yes in a number of situations. Would you open a savings account with a bank whose
bonds have a very high chance of default, say junk bonds? Would you buy a life insurance
policy from a company that does not have a high quality bond rating? Obviously not.

Conversely, that is why banks and insurance companies try to maintain a high
quality rating, otherwise they would have a tough time competing for
customers.

Note for the table below. At times, both agencies use adjustments. S&P uses "+" or "-" to
indicated strength or weakness, Moody's uses 1, 2, or 3, with 1 being the highest.

By Alex Tajirian, adapted.


Rating Agency

Moody's S & P's/Fitch Investment Description


Quality

Aaa AAA Highest grade Prime. Maximum safety.Very strong capacity to pay
interest and principal.

Aa1 AA+ High grade High grade. High quality. Strong capacity to pay.

Aa2 AA

Aa3 AA-

A1 A+ Medium Upper medium grade. Bond is more susceptible to


Quality adverse changes.

A2 A

A3 A-

Baa1 BBB+ Low Quality Lower medium grade.

Baa2 BBB

Baa3 BBB-

THE GRADES ABOVE ARE “INVESTMENT GRADE”

Ba1, B BB+ Poor quality Speculative

Ba2 BB

Ba3 BB-

B1 B+ Very poor Highly speculative


quality

B2 B

B3 B-

Caa, Ca, CCC+, CCC, Substantial Highly speculative in their ability to meet interest
C CCC- risk and principal obligations

D D In default Interest and/or repayment are in arrears.

Unrated Unrated "Junk bonds" High risk,demand detailed knowledge of issuer.

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