How Are Bond Ratings Determined?

Bond ratings may look like alphabet soup, but there's plenty of method and important information contained in them. A bond is a promise by the issuer to the bondholder, not only to make timely interest payments, but to return that investor's principal when the bond matures. Bond ratings offer guidance to how creditworthy an issuer is. The higher the rating, the less likelihood of default, and the lower the interest rate the issuer needs to offer to sell all the bonds. A low rating means a higher interest rate, but higher risk of default. The major U.S. credit rating agencies are Moody's, and Standard & Poor's. While they may have different ratings algorithms, they both look at the same key criteria. They both classify bonds broadly as investment grade, which has lower risk of default, and speculative, with higher risk.

Predictability of Cash Flows

This is a key area of investigation for a bond rating. A reduction in an issuer's cash flow will drastically limit its ability to make interest and principal payments. Ratings analysts look at the issuer's operating budgets and forecasts. In the case of government issuers, they look at spending and revenue plans, such as future tax revenues and pension obligations.

Adverse Scenarios

A ratings agency estimates each issuer's response to a selection of possible future scenarios, both at the broader macroeconomic level, such as a rise in interest rates or a recession, and at a level more specific to the individual issuer, such as losing key clients or the entry of a new competitor to the field. The ratings agency calculates the probability of each scenario, and the degree to which each will affect the issuer's ability to meet its bond payment obligations.

Default Severity

Ratings include an estimate of the probability of default on debt, and of the expected loss in the case of default. An issuer may pay some of its obligations but not all, so the expected loss may be less than 100 percent of its debt, or it may mean late payments rather than no payment at all. The seniority of the debt is considered during the ratings process.

Sector Specific

Once a ratings agency assesses the basic financial picture of an issuer, it takes a closer look at sector-specific risks and scenarios. This may include assessing demographic trends or understanding the effect of future regulatory changes on the industry. For example, a wide, sweeping change in financial market regulation will affect all issuers in the sector, and, depending on the role of the company being rated, may be positive or negative.

"Insider" Information

While it's a crime to trade for profit on insider information, ratings agencies often rely on such information to determine the financial outlook for a particular company. Analysts cannot disclose the details, but they can use the information for the purposes of rating. It may be in a company's best interests to let Moody's or Standard & Poor's know about big upcoming deals if it means a better rating and a lower interest rate when they issue debt to finance new projects.

Monitoring

Factors such as changes in company policies, the general economy, and demographic shifts constantly influence an issuer's financial situation. Ratings agencies monitor key developments and watch for situations affecting future creditworthiness. When a change is large enough, an agency may issue a revised credit rating. An improvement in the rating will result in lower interest rates on debt, as well as a change in price on any debt already issued. If a credit rating falls, interest rates will increase on both current and future debt.

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