What Is a Bond Rating?
A bond rating is a way to measure the creditworthiness of a bond, which corresponds to the cost of borrowing for an issuer. These ratings typically assign a letter grade to bonds that indicate their credit quality. Private independent rating services such as Standard & Poor's, Moody’s Investors Service, and Fitch Ratings Inc. evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest, in a timely fashion.
Key Takeaways
- A bond rating is a letter-based credit scoring scheme used to judge the quality and creditworthiness of a bond.
- Investment grade bonds are assigned “AAA” to “BBB-" ratings from Standard & Poor's and Fitch, and "Aaa" to "Baa3" ratings from Moody’s. Junk bonds have lower ratings.
- The higher a bond's rating, the lower the interest rate it will carry, due to the lower risk, all else equal.
- The bond rating agencies rate all types of bonds, from corporate bonds to sovereign bonds.
Understanding Bond Ratings
Most bonds carry ratings provided by at least one of the following three chief independent rating agencies:
- Moody's Investors Service
- Fitch Ratings Inc.
To determine a bond's rating, these agencies conduct a thorough financial analysis of a bond's issuing body, whether they are U.S. Treasuries or bonds from international corporations.
Based on each agency’s individual set of criteria, analysts determine the entity’s ability to pay their bills and remain liquid, while also taking into consideration a bond's future expectations and outlook. The agencies then declare a bond's overall rating, based on the collection of these data points.
Pricing, Yield, and a Reflection of Long-Term Outlook
Bond ratings are vital to alerting investors to the quality and stability of the bond in question. These ratings consequently greatly influence interest rates, investment appetite, and bond pricing.
Higher-rated bonds, known as investment-grade bonds, are viewed as safer and more stable investments. Such offerings are tied to publicly traded corporations and government entities that boast positive outlooks.
Investment grade bonds contain “AAA” to “BBB-" ratings from Standard and Poor's and Fitch, and "Aaa" to "Baa3" ratings from Moody’s. Investment-grade bonds usually see bond yields increase as ratings decrease. U.S. Treasury bonds are the most common AAA-rated bond securities.
Non-investment grade bonds (junk bonds) usually carry ratings of “BB+” to “D” for Standard and Poor's and Fitch, and "Baa1" to "C" for Moody’s. In some cases, bonds of this nature are given “not rated” status. Although bonds carrying these ratings are deemed to be higher-risk investments, they nevertheless attract certain investors who are drawn to the high yields they offer. Some junk bonds are saddled with liquidity issues, however, and can feasibly default, leaving investors with nothing.
In Aug. 2023, Fitch Ratings downgraded the long-term ratings of the United States to "AA+" from "AAA" due to the anticipated fiscal deterioration over the next three years, increasing government debt burden, and the erosion of governance related to "AA" and "AAA" rated peers over the last two decades that has resulted in repeat debt limit standoffs and 11th-hour resolutions.
Role of the Rating Agencies in the 2008 Financial Crisis
Many Wall Street watchers believe that the independent bond rating agencies played a pivotal role in contributing to the 2008 economic downturn. In fact, it came to light that during the lead-up to the crisis, rating agencies were bribed to provide falsely high bond ratings, thereby inflating their worth. One example of this fraudulent practice occurred in 2008 when Moody's downgraded 83% of $869 billion in mortgage-backed securities, which were given a rating of "AAA" just the year before.
In short: long-term investors should carry the majority of their bond exposure in more reliable, income-producing bonds that carry investment-grade bond ratings. Speculators and distressed investors who make a living off of high-risk, high-reward opportunities, should consider turning to non-investment grade bonds.
Why Do Bonds With Lower Ratings Have Higher Yields?
Bonds with lower ratings have a greater risk of default than bonds with higher ratings. These bonds tend to have higher yields so as to still be able to entice investors, despite bringing greater risk.
What Is a Junk Bond?
Bonds that are non-investment grade are considered to be high-yield or "junk" bonds. They are considered to be high-risk and usually have ratings of "BB+" to "D" or not rated. Investors can profit through buying junk bonds, but they also are at greater risk of losing their investment, as these kinds of companies tend to have liquidity issues.
What Is an Investment Grade Bond?
An investment-grade bond is a so-called high-quality or low-risk bond. It is considered to be a fairly safe bet and has a very low rate of default. Bonds rated "AAA," "AA," "A," and "BBB" are considered investment grade.
The Bottom Line
A bond rating is a grading given to a bond that indicates its creditworthiness. Bond ratings are assigned by agencies, such as Moody's, Standard & Poor's, and Fitch Ratings, and reflect an analysis of the bond issuer's financial strength or capacity to pay a bond's principal and interest.
The rating organizations assign grades to the bond, such as "AAA," which indicates lower risk, or "B-," which indicates greater risk. Higher-risk bonds offer higher yields, while lower-risk bonds offer lower yields.
