Bond Grades: How to Understand Them & 4 Factors That Affect Bond Ratings

By Chika

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Last Updated: November 10, 2022

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The Federal Reserve approved a fourth consecutive 75-basis point rate hike. The move signaled the most aggressive pace of monetary policy tightening from the US central bank since the early 1980s. 

For investors, the series of continuous rate hikes have caused a huge dent in portfolios as valuations of stocks have plummeted.

One asset which has benefited from the aggressive rate hikes is the bonds. Yields on US bonds have risen to their highest level in over a decade, topping 4%. 

The relative safety of bonds, rising yields, and the stickiness of inflation have made this usually boring asset attractive to investors. However, not all bonds are worthwhile investments for your money. One way investors can filter junk from substance is by looking at the ratings. 

In this article, we take an in-depth look at bond ratings and how investors can use this to choose bonds to invest in.

 

 

What are bond ratings?

Bond ratings perform the same function as credit ratings.

They are scores issued by rating agencies (Moody's, Standard & Poor's, and Fitch) that indicate the creditworthiness of the bonds. 

Creditworthiness in this sense means the issuer's ability to meet the financial obligations of making interest payments and repaying the loan in full at maturity.

Since bonds, like other financial assets, operate on a risk-reward basis, ratings also affect the yield. As such, lower-rated bonds usually offer higher yields to compensate investors for the additional risk. 

Though each rating agency uses its grading system, they all classify bond investments by quality grade and risk. 

Let's have a look at the different bond ratings:

 

Rating 

Description

Investment

Standard & Poor/Fitch

Moody's

AAA

Aaa

Extremely strong capacity to meet financial obligations.

Premium

AA+

Aa1

Very strong capacity to meet financial obligations.

High Grade

AA

Aa2

Very strong capacity to meet financial obligations.

High Grade

AA-

Aa3

Very strong capacity to meet financial obligations.

High Grade

A+

A1

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Upper Medium Grade

A

A2

Strong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.

Upper Medium Grade

BBB+

Baa1

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Lower Medium Grade

BBB

Baa2

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Lower Medium Grade

BBB-

Baa3

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Lower Medium Grade

BB+

Ba1

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

Non-investment grade speculative

BB

Ba2

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

Non-investment grade speculative

BB-

Ba3

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

Non-investment grade speculative

B+

B1

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

Highly speculative

B

B2

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

Highly Speculative

B-

B3

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

Highly Speculative

CCC+

Caa1

Highly vulnerable; default has not yet occurred but is expected to be a virtual certainty.

Substantial risk

CCC

Caa2

Highly vulnerable; default has not yet occurred but is expected to be a virtual certainty.

Extremely speculative

CCC-

Caa3

Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

Default imminent

CC

Ca

Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.

Default imminent

C

Ca

Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.

Default imminent

D

C

Payment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken.

In default

NR

 

The security was not rated.

 

 

What Are Investment-Grade Bonds?

Bonds classified as investment grade have a rating of BBB-/Baa3 or higher.

These bonds are regarded as investment-worthy by the rating agencies, with a manageable level of risk and a low probability of default.

Investment-grade bonds are the ideal choice for investors wishing to place their money in a security that is expected to receive both a stable yield and a return of principal. These bonds may, however, bring lesser yields than trash bonds with higher levels of risk due to their low risk and stability.

 

 

What Are Junk Bonds?

Junk bonds are those with a rating of BB+/Ba1 or lower, commonly referred to as non-investment grade bonds or high-yield bonds. Junk bonds have a higher default risk than investment-grade bonds. They are thought of as speculative investments with a low to high default risk. 

To put it another way, even though bonds are typically seen as less hazardous investments than stocks, these junk bonds could carry more risks than stocks. These higher-risk bonds typically have to pay out higher interest rates as a result, in significant part.

 

 

4 Factors that Affect Bond Ratings

1. The creditworthiness of the issuer

The issuer's credit risk has the most impact on the bond rating.

The capacity of the business to pay back its debts to its creditors is known as credit risk. The bond rating drops if the company's creditworthiness declines. The issuer's balance sheet strength, ongoing business operations, profit margins, and earnings growth are all factors that affect creditworthiness.

 

2. Track record

Credit rating agencies look back at the track record of the issuer. An issuer that demonstrates that its current financial stability is not likely to change shortly usually receives a high credit rating and vice versa.

 

3. Corporate events

Positive or negative corporate events have an impact on a company's bond.

The introduction of a new product is a successful corporate event, whereas a corporate scandal is a negative one. When assigning ratings, credit rating companies take these occurrences into account.

Negative business events receive a poor credit rating, whereas positive corporate events receive a high credit rating.

 

4. The strength of the economy

When a government issues bonds, the strength of its economy is gauged by investors.

This determines the government's ability to meet its debt obligations.

Metrics such as the following are among the factors which investors use to understand the strength of the economy. 

  • GDP growth
  • unemployment rate
  • political risks
  • the value of the currency
  • trade deficit 

Countries with strong economies usually have lower yields because the risk of default is low. On the other hand, countries with weak economies offer high yields to compensate for risks because the risk of default is higher. 

 

 

Importance of Bond Ratings

Bond rating agencies play an important role in credit laws and regulations in the United States. 

They remain one of the essential sources of information regarding credit analysis and credit risk for investors. Additionally, rating agencies have a big impact on the world financial markets by giving investors an evaluation of assets.

 

 

How to Use Bond Ratings When Investing in Bonds

Bond ratings are used by investors to assist them to choose which bonds are worth their money.

However, most regular investors choose to invest in bond funds that contain a diverse mix of bonds with specific ratings rather than sifting through hundreds of individual bonds.

No matter if you decide to purchase funds or individual bonds, keep in mind that rating agencies only consider a company's present financial status.

Bond rating agencies may not yet have taken into effect the predicted income source's deterioration in their assessments.

Given this, you should keep in mind that bond ratings are simply one of the resources available to investors for assessing bond investments. It shouldn't be the sole metric taken into account when investing in bonds.

Investors should not, however, entirely depend on the credit ratings offered by credit rating companies.

The world financial crisis of 2007–2008 demonstrated the potential for conflicts of interest to arise from the strong ties between credit rating agencies and major financial institutions.

For instance, numerous mortgage-backed securities that were very close to the category of junk securities were given the highest ratings by credit rating organizations.

Photo by RODNAE Productions

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