Rating corporations for their ability to fulfill their bond obligations
Credit rating agencies rate most of the larger companies and municipalities for their credit worthiness. The rating is based on the companies or municipalities financial strength – this is their ability to pay creditors such as bondholders any coupon payments due and the return of the bonds principle.
The credit rating is for the company’s ability to pay its creditors rather than its ability to grow its earnings. Thus a company may have a high credit rating but that does not mean it is a high growth stock. Also the credit ratings are not buy and sell recommendations for a stock or even a bond.
These credit ratings are intended to help bond investors in making an investment decision regarding a particular bond. The higher the credit rating, then the higher the probability that the bondholder will receive all of their coupon payments along with the return of their principle at maturity.
The credit rating is a measure of the risk of default with the bond issuer in not meeting their obligations. As a general rule, the lower the credit rating then the higher the coupon payment. Thus as the risk of default increases, the bond’s yield increases.
There are two major credit rating agencies which combined have around 80% of the credit rating business. They are Moody’s and Standard & Poor’s. These two basically use the same credit rating system and only differ slightly in the rating convention used.
The rating scale used by both Moody’s and Standard & Poor’s is shown below in Table 1.
Table 1. Corporate credit ratings
From Table 1. above both Moody’s and Standard & Poor’s broadly split the Bond grade into investment grade and speculative grade.
Moody’s
- Moody’s classifies bonds as investment grade if they are rated Aaa down to Baa3.
- Moody’s classifies bonds as speculative grade if they are rated Ba1 down to C.
Standard & Poor’s
- Standard & Poor’s classifies bonds as investment grade if they are rated AAA down to BBB-.
- Standard & Poor’s classifies bonds as speculative grade if they are rated BB+ down to D.
Note that the Bond grade in default means that the company or municipality has stopped making coupon payments – not that they are in bankruptcy, even though they might be.
Treasury bonds not rated by the ratings agencies since treasury bonds are backed by U.S. treasury and as such are essentially guaranteed – so there is virtually no risk of default.
The highest ratings given to bonds by the rating agencies are Moody’s Aaa and Standard & Poor’s AAA – these are the safest bonds with only a slight chance of default (generally well under 1%) and due to their high degree of safety generally only pay a small premium over treasury bonds.
The further down the ratings scale then the higher the interest rates tend to be for the same maturity. Thus the low investment quality bonds pay higher interest rates than prime investment quality bonds for a similar maturity, but the risk of default increases to around 10%.
The speculative grade bonds are usually called Junk bonds or High-yield bonds. The highest grade of junk bonds are still speculative and the lower grade junk bonds are those with a high risk of default (which can be around 20%).
Investors love high-yield bonds, but be aware
that these are junk bonds with a high default risk
The rock bottom quality junk bonds are those that are currently defaulting on their obligations. This does not necessarily mean they cannot regain their ability to meet their obligations but the probability is of this occurring is low. Bonds with this rating will rarely see the full face value returned.
Speculating with these junk bonds is speculative trading that hedge funds are active with and for the most part are not suited for investing purposes.
Even if an investor buys investment grade bonds, there is always the risk that the credit rating can change in the future.
In the future a company or a municipality can be downgraded or even upgraded. If it’s downgraded then the bond value will drop and if it’s upgraded then bond value will increase – this is due to perceived risks in receiving the coupon payments and the return of principle.
Also diversification becomes increasingly important as the ratings decline – even for investment grade bonds. Generally it is not a good idea to only buy bonds issued by the one company. It’s best to diversify by buying bonds from different companies in different industries. If the investor has insufficient capital then it is generally better if a bond fund is used.