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.
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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.
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.