What are bond ratings?
Bond ratings measure the safety of a particular bond. Financial information companies, such as Moody's, Standard & Poor's, and Fitch Ratings compile data on the financial strength of the bond issuer and assign a rating.
Not all bonds carry ratings. Bond issuers pay a fee to financial information companies to have their bonds rated. If the total value of a bond offering is too small to justify the cost of having it rated, a bond may be issued without a rating. However, just because a bond has not been rated does not necessarily mean that it is an unsound investment.
Tip: U.S. Treasury bonds are not rated. As obligations of the federal government, they are assumed to be secure investments.
Factors determining a bond's rating
Rating services evaluate the financial strength of the issuer. They look at the issuer's outstanding debt and growth rate. They also examine the industry and the state of the overall economy.
Rating services evaluate the financial position of a state or city in the same way as they do a company. They examine the municipality's outstanding debt, growth rates of revenues and spending, condition of the overall economy, and the condition of other municipalities.
Moody's, Standard & Poor's, and Fitch, the three most well-known rating services, use a letter grade scale for their bond ratings.
A letter grade also may be modified to indicate relative standing within a particular letter grade. Moody's uses numbers (1, 2, or 3) as modifiers; Standard & Poor's and Fitch use pluses and minuses. For example, Aaa1 would be Moody's highest rating, while AAA+ would be the highest given by the other two services.
Classes of bonds
"Investment grade" usually refers to any bond rated Baa, BBB, or higher. Some bond mutual funds limit their holdings to investment grade bonds.
Bonds with a Standard & Poor's or Fitch rating of BB or lower (Ba by Moody's) are considered to be speculative investments. They are often called junk bonds or high-yield bonds because they have to pay higher interest rates to attract investors.
Bond ratings and bond prices
Credit ratings influence a bond's yield. Companies and governments with lower bond ratings must pay higher interest rates on the debt they issue, in order to get people to buy their bonds.
Rating services periodically review the ratings of a company or a government during the life of a bond. If the organization's financial outlook has changed, the rating service can reflect that change by either upgrading or downgrading the bond.
A change in the rating of a bond will have an effect on the bond's price in the secondary market. If the bond is downgraded, investors will demand a higher yield to compensate for the increase in credit risk. This means that the price of the bond in the secondary market will fall. On the other hand, if the bond is upgraded, the secondary market price will rise.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2017.