Bonds are essentially IOUs, issues of debt with a promise to pay you back — and then some. The decision to lend money is easier when the borrower is good for it. It may also be an easy choice (in the opposite direction) when you know the borrower’s finances are shaky. But when the borrower is a large corporation, nonprofit organization, government or municipal entity, how do you judge the financial outlook for that type of debt?
Enter bond ratings, which are like FICO scores for fixed-income investments. These handy grades, given by independent rating agencies, are crucial to how a bond is perceived and priced. Before you invest in bonds, it’s essential to have a good understanding of bond ratings — what they are, what they mean and how they impact your portfolio.
What are bond ratings?
A bond rating is a forward-looking measure of the financial health of a bond issuer and the creditworthiness of a bond. In other words, it helps investors get a sense of how likely it is that the bond will be paid until maturity and be redeemable. Bond rating agencies evaluate corporations, government and municipal entities, banks, insurers and nonprofits (such as hospitals and utilities) by assigning letter grades to indicate a degree of credit risk. This helps to determine the yield of the bonds issued.
Three main agencies rate bonds: Moody’s Investor Service, Fitch Ratings and Standard & Poor’s (S&P) Global. All use similar rating scales with some minor differences to rate bonds from highest credit quality and lowest risk of default, which the market refers to as investment grade, to lower credit quality and higher risk of default, or non-investment-grade, which are more speculative. It also rates the lowest quality bonds already in default.
New bonds are typically rated when they come to market, with bond issuers paying for the privilege of being rated.
Bond ratings explained
All three rating agencies measure short-, medium- and long-term creditworthiness along a relative spectrum. The long-term rating systems are probably most familiar to investors, with triple-A ratings for bonds at the strong end of the investment grade spectrum and triple-B for low-quality bonds at the weak end.
Non-investment grade bonds begin around double-B rated through double-C. These C or D ratings indicate a bond issuer is near or in default, which means the bond fails to make interest payments on time or the bondholder cannot redeem the principal at maturity.
|Long-term investment-grade ratings (strongest to weakest)|
|Long-term non-investment-grade ratings (strongest to weakest)|
|Moody’s||Fitch||Standard & Poor’s|
Bonds issued directly from the U.S. government, such as Treasury securities and savings bonds, are not rated. Because they are backed by the full faith and credit of the federal government, these issues are generally considered free of default risk. Municipal or “muni” bonds, which are issued by states, cities, counties or other municipalities to fund regional projects, are rated. Corporate bonds are rated as well.
Agencies consider the issuer’s relative ability and willingness to meet financial commitments and pay debts when due to determine a bond’s rating. They will look at financial balance sheets, outstanding debt and payment obligations, growth and spending rates, and the general state of the economy. A bond’s rating will also take into account things that would help the issuer recover from a financial setback, such as collateral, insurance, guarantors, bankruptcy protections and any other arrangements that may impact the risk of the bond. The more money available to cover the debt issued, the higher the rating of the bond.
Ratings are relative and presented as subjective rather than fact. They are not meant to be taken as endorsements for or against an investment. Sometimes, even the rating agencies do not agree on a bond’s risk. Still, of all the things that can influence a bond’s price, ratings have a major impact.
How do bond ratings impact prices?
To understand how ratings can impact bond prices, think back to the example of a borrower with an IOU. Borrowers with excellent credit typically pay less interest on loans, and borrowers with bad credit are likely to pay higher rates of interest to compensate for the risk. The same is true for bond issuers.
Government bonds, considered risk-free, pay the lowest interest rate yields. Muni bonds range more in quality, but also have low default rates. Muni bond rates will often vary depending on the level of speculation in the investment. Corporate bond yields vary according to the financial health of the company, and can also be highly speculative. Low-rated bonds attempt to make up for poor creditworthiness with higher yields, and are known as high-yield or junk bonds.
Bond ratings are updated throughout the life of a bond, and a rating can be upgraded or downgraded over time. Even the hint of an upgrade or downgrade may move prices as anxious bond traders try to gain an edge. If the agencies downgrade a bond’s credit rating, the bond will become less attractive as an investment and may fall in value. If a bond is upgraded, more investors may want to own it and it may rise in value.
How much could your investment move on a rating downgrade? For the highest quality bonds, rated AAA or AA, the impact will likely be small. But continued downgrades or a downgrade spiral leading to a bond falling below investment-grade could put your investment at risk.
However, if you plan to hold onto the bond until maturity, upgrades and downgrades are unlikely to impact on your investment. As long as the bond issuer continues to make timely interest payments and you can redeem your principal at the end of the bond’s term, price changes in the bond shouldn’t matter to you. While there may be some risk of default for a bond that’s downgraded, it’s rare for a bond rated “A” or better to be downgraded to default. On the other hand, if your bond is upgraded it could increase in price and you may decide to sell the bond before maturity.
Credit ratings are not an exact science. There are times when credit rating agencies fail at their job, as they did with mortgage-backed securities in the run-up to the financial crisis of 2008. That was a case of agency oversight, possibly due to conflicts of interest. There have since been changes in rating agency oversight and accountability, and bond ratings remain the best guide investors have to determine creditworthiness.
If individual bonds are part of your portfolio, it helps to keep a watch on credit ratings to judge the relative health of the investment. Better yet, you can reduce your risk by owning a diversified portfolio of bonds through a fixed-income mutual fund or exchange-traded fund (ETF).