Bond Ratings - Explained
What are Bond Ratings?
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Table of ContentsWhat is a Bond Rating?How Does a Bond Rating Work?Academic Research on Bond Ratings
What is a Bond Rating?
This is a rating that is given to a bond to show its credit quality. These ratings are provided by private independent rating services based on the financial strength of a bond issuer. These ratings are expressed as letters which range from the highest AAA' to the lowest C' or D.' Although the grades use the same letters in every rating service, some of these services use combinations of upper and lower case letters to differentiate themselves.
How Does a Bond Rating Work?
This rating system enables investors to evaluate the credit risk of companies. The blue-chip companies have a higher rating since they are safer than the risky companies which have a low rating. The below bond rating scales are from Moody's, Standard and Poor's, and Fitch ratings which are leading rating agencies in the US.
|Ba, B||BB, B||Junk||Speculative|
When the company's status falls below a particular rating, its grade is changed from investment quality to junk status. The junk bonds are those belonging to companies that are in some financial trouble. This means that they offer higher yields than other debts since they are so risky. Bonds are not safer than stocks, and some type of bonds can be riskier than stocks. The rating of the creditworthiness of a bond issuer is an art and a science. Even though rating companies gather and analyze large amounts of data to decide the best grade, the rating finally relies on the informed opinion of an analyst or a rating committee. The rating is done after a critical analysis of a firm's financial history. The ability of the company on timely repayment is also analyzed based on previous bonds issued and paid. Usually, the bond ratings are reviewed every six to twelve months although the agency may decide to review a bond at any time for various reasons such as delayed payments, issuance of new bonds, changes in the financial aspects of the issuer and many others. The results by bond rating agencies are relied upon by individual and institutional investors to make prudent investment decisions. These agencies can influence the success of a company in the primary and secondary bond markets. However, since the financial crisis of 2008, the value of these ratings has been widely questioned, and the timing and opinions of these agencies have been criticized due to dramatic downgrades. Investors should thus supplement these ratings with their research before making a financial decision. Sometimes firms will not have their bonds rated, and the investors will be required to judge the firm's repayment ability on their own. Because ratings differ for each agency and also keep changing, the definition for the bond rating being considered should be researched.
Academic Research on Bond Ratings
- Effect of corporate governance on bond ratings and yields: The role of institutional investors and outside directors, Bhojraj, S., & Sengupta, P. (2003). The Journal of Business, 76(3), 455-475. This paper proves the link existing between corporate governance mechanisms and higher bond ratings together with lower bond yields.
- Statistical models of bond ratings: A methodological inquiry, Kaplan, R. S., & Urwitz, G. (1979). Journal of business, 231-261. This article summarizes and then criticizes the models developed for the prediction of bond ratings. It applies a statistical procedure that is appropriate to the ordinal nature of a bond rating to a sample of seasoned and newly issued bonds.
- A multivariate analysis of industrial bond ratings, Pinches, G. E., & Mingo, K. A. (1973). The journal of Finance, 28(1), 1-18. This study attempted to develop and test a factor analysis/multiple discriminant models to be used in predicting industrial bond ratings.
- The longrun stock returns following bond ratings changes, Dichev, I. D., & Piotroski, J. D. (2001). The Journal of Finance, 56(1), 173-203. This study aims to find abnormal returns after upgrades which are reliable by using Moody's bond ratings changes between 1970 and 1997.
- An alternative approach to predicting corporate bond ratings, West, R. R. (1970). Journal of Accounting Research, 118-125. This paper criticizes various aspects of Horrigan's methodology and argues that a different approach to the predicting problem of corporate bond rating might be more accurate. The article then presents the results which are obtained by the application of this alternative approach.
- The information value of bond ratings, Kliger, D., & Sarig, O. (2000). The journal of finance, 55(6), 2879-2902. This article tests if bond ratings have the pricing-relevant information by the examination of security price reactions to Moody's refinement of its rating system.
- Classification models and bond ratings, Ederington, L. H. (1985). Financial review, 20(4), 237-262. This paper considers the options available to the investigators of bond ratings and to what extent their results are sensitive to the researcher's model choice.
- The role of subordination and industrial bond ratings, Pinches, G. E., & Mingo, K. A. (1975). The Journal of Finance, 30(1), 201-206. This paper argues that the subordinated status of a bond is the most crucial variable in a model as represented by a 0-1 dichotomous key.
- Bond ratings, bond yields and financial regulation: Some findings, West, R. R. (1973). The Journal of Law and Economics, 16(1), 159-168. This study concludes that bond quality ratings are a source of interest to economists and practical men of affairs.
- Bond ratings, bond yields and financial information, Ziebart, D. A., & Reiter, S. A. (1992). Contemporary Accounting Research, 9(1), 252-282. This paper investigates if bond ratings have a direct impact on bond yields and also how accounting information affects bond yields whether directly or indirectly through the bond ratings. It also clarifies the role of accounting information when it comes to setting bond market prices.
- Does it matter who pays for bond ratings? Historical evidence, Jiang, J. X., Stanford, M. H., & Xie, Y. (2012). Journal of Financial Economics, 105(3), 607-621. This study conducts a test to see if standard and Poor's assigns higher bond ratings after it switched from investor-pay to issuer-pay fees in 1974.
- The effect of CEO power on bond ratings and yields, Liu, Y., & Jiraporn, P. (2010). Journal of empirical Finance, 17(4), 744-762. This study attempts to find out the impact of CEO power or CEO dominance on the bond ratings and yield spreads.