Wednesday, February 9, 2011

Bond Credit Ratings

As a bond investor, you want reasonable assurance that you will get your interest payments and principle back at maturity. It is impossible for individual to track the credit worthiness of individual bond issues. Fortunately, rating services such as Moody’s Investors Service (Moody’s) and Standard & Poor’s Corporation (S&P) provide this valuable service.

These rating services pore through voluminous financial statements and study the business prospects of bond issuers to answer the question, “How likely is the issuer to default on its payments on a particular bond issue?” Bonds that rank low in terms of risk receive a higher quality rating.

Bond credit ratings are assigned to a particular bond issue, not just to the issuer of those bonds. For example, a secured bond issue gives the investor a claim to specific assets in the event of default. This gives a secured bond a higher credit rating than an unsecured bond even when issued by the same corporation.

The top four grades (Aaa, Aa, A and Baa in the case of Moody’s; or AAA, AA, A and BBB in the case of S&P’s) are considered investment grades. All other grades are considered high-yield or junk.

Moody’s / S&P Ratings:
Investment-Grade Bonds:
Aaa / AAA => Highest credit rating, maximum safety
Aa/ AA => High credit rating, investment-grade bonds
A/A => Upper-medium quality, investment-grade bonds
Baa/BBB => Lower-medium quality, investment-grade bonds

Speculative Bonds:
Ba / BB => Low credit quality, speculative-grade bonds
B/ B => Very low credit quality, speculative-grade bonds

Junk Bonds:
Caa / CCC => Extremely low credit quality, high-risk bonds
Ca / CC => Extremely speculative
C /C => Extremely poor investment
D / D => Bonds in default

As Shown below, credit rating influence the interest rate an issuer must pay to attract investors. Given the same maturity, the higher a bond’s rating, the lower the interest it pays. On the other hand, the lower a bond’s rating, the more an issuer must pay. That is why the lowest-rated bonds are often described as high-yield bonds.

Bonds Grades Versus Yield

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