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Bond Credit Ratings

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In order to be listed for trading, issuers must acquire a rating from credit ratings agencies. These agencies assign a rating based on the ability of the issuer to make repayments on their bonds. The ratings mostly focus on financial strength, but also include the usage of funds, the regulatory or political environment, and potential changes to economic situations.

Credit Rating Agencies

There are two ways for a bond to receive a rating. The first is for an issuer to hire a ratings agency to rate the product which can give rise to conflicts of interest. Agencies paid to rate may not be completely neutral with their ratings. The second is for the ratings agency to choose to rate the product. This is decided by the ratings agency itself. However, there are only three major ratings agencies. These are Moody’s, Standard and Poor’s, and Fitch. Assuming all agencies have rated the same instrument or issuer, if one rating is substantially above or below the others it may indicate a problem. It should be noted that ratings are not always in perfect alignment.

Note: During the 2008 financial crisis, several ratings agencies were caught selling credit ratings for mortgage backed securities. They stated that ratings were only their “opinion” on the asset, and first amendment rights protected their choice in ratings. Always analyze the potential instrument’s underlying fundamentals to ensure that the firm or nation can actually repay their debt obligations. Review the multi-year trends in Debt to Equity Ratio, Existing Debt Levels, Weighted Cost of Capital, Revenue, Earnings Before Interest and Taxes, Financial Leverage, and Return on Assets versus Interest Coverage. These will help you ensure they actually deserve the credit rating they’ve been assigned.

Investment Grade

Credit ratings begin with AAA and Aaa. This rating indicates the highest percentage chance to repay both interest and principal at the end of the bond’s term. This is an extremely strong and incredibly rare rating that only goes to a few firms, investment vehicles, and sovereign nations. This rating will be able to repay no matter what happens in the economy or business sector at the time of rating. The vulnerability of firms to economic and business sector risks increases, alongside the rate of default, as ratings move down from AA+, AA, or Aa1. The chances of default remain relatively low during the investment grade, represented on the chart in green. During this level the firm’s ability to repay interest is known as excellent to adequate.

Speculative/Junk Bond Grade

The investment grade begins at the top rating and descends to BBB, BBB-, or Baa3. Below BB, BB-, or Ba1 the speculative grade begins. Although debt may have some ability to return interest and principal, these firms have significantly more likelihood to default. The chance of default, as well as the rate of default, increases significantly until the final rating level, which signifies firms which are already in default. Returns within this grade are high, but they are also reduced out by the rate of defaults. During economic or industry sector downturns, default rates within the speculative investment grade skyrocket. Bonds within the speculative grade are nicknamed “High Yield” and “Junk Bonds” due to these tendencies.

Default Chance Only

Credit ratings only indicate the chance that the firm will default. They do not rate based on distress or value decreases of the investment. The rating does have an impact on the value of the investment. If two investments have the same yield, but one is rated higher than another due to a justifiable reduction in chance to default, investors will typically bypass investment in the lower rated instrument. There’s no reason for you to purchase an investment with more risk and the same yield as a low risk instrument. This means that a lower rated investment must return a higher yield than high rated investment, or it will not sell. The rating will affect the bond’s price, since it will affect its likelihood to be purchased by other investors. Ratings can change after issue, and they will affect the market price after purchase. If the interest rate does not change, then the price will fall.

Credit Rating Speculation

Ratings also control who can invest in an issue. Some classes of institutional investors can only purchase specific ratings or higher. Pension funds, Retirement funds and Insurance companies cannot purchase below high end investment grade bonds. They handle other people’s lives and cannot take riskier ratings. Some funds of institutional investors can only purchase a range of specific ratings. These funds must match the risk guideline it issued within their prospectus, by purchasing within the ratings range they stated.

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