How Are Bond Ratings Determined?

A bond is a financial promise issued from a corporation or government to an investor. This promise states that in exchange for an investor's money, a bond issuer will make regular interest payments and ultimately return an investor's principal investment. However, this promise is only as sound as the financial capability of the bond issuer.

In spite of that promise, some bond issuers end up defaulting on their obligations, and investors can lose money. Bond ratings are one way of evaluating the risk that a bond issuer will make good on its debt obligations.

Who Assesses Bond Risk?

Bond ratings are determined by third-party rating agencies. This helps keep the evaluation of bonds independent and objective. The three main rating agencies – Fitch, Standard & Poor's and Moody's – each assign slightly different ratings to bonds, although the overall scales are meant to be comparable.

Rating agencies are not government entities; rather, they are for-profit corporations in their own right. Moody's, Standard & Poor's and Fitch assign ratings to bonds in exchange for cash payments. As corporations, this is one of the ways in which they earn money for shareholders.

Bond Rating Scale

Rating agencies assign their ratings of a firm's bonds based on the financial strength of the underlying company. Essentially, bonds are assigned ratings between some version of AAA and D, with AAA-rated bonds representing the most financially secure companies.

The Standard & Poor's rating scale is as follows:

• AAA (extremely strong)
• AA (very strong)
• A (strong)
• BBB (adequate)
• BB (faces major ongoing uncertainties)
• B (adverse conditions will impair payment capability)
• CCC (currently vulnerable to nonpayment)
• CC (highly vulnerable to nonpayment)
• C (highly vulnerable to nonpayment)
• D (in default)

Within each of these categories, ratings can be modified by + and - indicators, such as "BBB+" or "AA-."

The Moody's rating scale is comparable:

• Aaa
• Aa
• A
• Baa
• Ba
• B
• Caa
• Ca
• C

What Bond Ratings Indicate

The top four ratings in each classification system are known as "investment grade" ratings. For example, bonds rated AAA, AA, A, or BBB under the Standard & Poor's rating system would be considered "investment grade." Investment grade bonds are, as a group, considered the most likely to have no problems paying off their debt obligations. Some investors, such as certain banks, insurance companies or mutual funds, are restricted to only buying investment grade bonds.

Bonds rated lower than investment grade are considered speculative. In the past, bonds rated CCC and lower were called "junk" bonds, and although the moniker still exists, these types of bonds are often referred to by the more euphemistic term "high yield."

To invest in high-yield bonds, an investor must be willing to risk losing both interest and principal. For this reason, lower-rated bonds are best left to expert traders, or at least to mutual fund managers who can disperse the risk for individual investors. Of course, with high risk can come high reward, which is why some investors dabble in this asset class.

How Are Bond Ratings Calculated?

Bond ratings are calculated using proprietary processes developed by the rating agencies. All aspects of an issuer's financial situation are considered, including future predictions of the industry or economy.

For corporate bond issuers, rating agencies will look at the cash flow of a company, its growth rate and its current debt load. Companies with large free cash flow, profits and few debt obligations are likely to garner higher ratings.

For government entities, similar metrics are involved, although the specifics are different. The U.S. government, for example, holds an AAA rating and likely always will, because it is seen as extremely unlikely to default on its debt, and it can always print additional money. A municipality, on the other hand, will be evaluated based on current revenue and spending, outstanding debt obligations and the financial condition of the underlying community.

In addition to raw financial data, the rating agencies look at various supplementary sources of information as well. Analysts will typically read through published reports on the financial health of bond issuers and will also interview the management of a bond issuer to discuss operational performance, risk management strategies and other relevant information.

What Factors Affect Bond Ratings?

Anything that makes a bond issuer more financially solvent will potentially increase its bond rating, while anything that is a financial negative may result in a rating downgrade. Increasing corporate profits, for example, give a company additional financial latitude to meet its debt obligations. Retiring existing debt, or refinancing it at a lower interest rate, can also increase the financial standing of a corporation, potentially leading to an upgrade.

Financial missteps, such as overspending on a new building or investing in a poorly performing area of the market, can sap a company's cash flow and result in a higher debt-to-equity ratio. This makes a company less likely to make its interest payments, potentially resulting in a rating downgrade.

What Is Bond Insurance?

Bond insurance protects investors from nonpayment of a bond. Just like you can buy insurance to protect your possessions in the event of a loss, bond insurance pays if a bond issuer goes bankrupt or can't otherwise make interest and principal payments.

Typically, corporate bonds stand on their own merits and are not insured. Municipal bonds, however, are often insured. Insurance kicks up a bond's rating to AAA, no matter what the underlying financials of the issuing entity are. This is because if the issuer defaults, the insurance company providing the coverage will pay off the bond.

Municipalities often pay for the extra insurance to make a bond issue more appealing to investors. While the financial situation of a publicly traded corporation must be disclosed, municipalities can be harder to analyze for investors. Bond insurance alleviates some of this concern because it provides an extra layer of safety.

Do Bond Ratings Change?

A bond rating is not a static assessment that sticks with a bond over the course of its life. Some bonds are issued with maturities of 10 years, 20 years or even 30 years or more. Over such long periods of time, the financial conditions of the underlying entities are likely to change, for better or worse.

After issuing an initial rating, agencies continually monitor the financials of bond issuers. If a bond issuer encounters financial difficulty and is less likely to be able to make bond payments, a downgrade may be issued. Similarly, if a company makes financial progress and become more financially sound, it may find that its bonds receive an upgrade.

Bond Upgrades and Downgrades

Upgrades and downgrades are important for both the bond issuer and for investors. Bond issuers can end up paying less interest after a rating upgrade, while bond investors can see some price appreciation after an upgrade.

For bond issuers, a rating upgrade means they can issue future debt under the upgraded rating. Higher-rated bonds typically pay lower rates of interest, so a company or government entity can benefit in the form of lower interest costs. These new bonds can be used to either finance future growth at a lower interest rate or to pay off older bonds that were issued at higher interest rates.

For example, let's say a company rated BBB issues a bond that pays 6 percent interest. All other things being equal, if the company sees an upgrade to A, they may be able to issue a bond paying just 5 percent interest. On a $10 million bond issue, one single percentage point of interest amounts to an additional $100,000 in interest per year, so refinancing that debt at a lower rate could be a good financial move.

From the perspective of an investor, a rating upgrade is a good thing because it can often translate into price appreciation, as higher-rated bonds are more in demand. Imagine two bonds rated CCC that are both paying the same 6 percent interest rate. If one of those bonds was upgraded to BBB, investors would gravitate toward it because it is safer in the eyes of the rating agencies; in other words, it's more likely that you'll get your interest and principal payments from the higher-rated bond, making it more valuable.

When investors buy more of a bond, the price tends to go up until it approximates the yield of other bonds with a similar rating. Although the stated interest rate would remain the same, the yield to maturity – or the total value of payments you would receive from a bond, including both interest and price appreciation – would go down.

Rating and Bond Defaults

Ultimately, the value of a bond rating is its ability to protect investors from losing their money in a default. While no assurances can be given that any individual bond issued will remain solvent, the lower the bond rating, the more likely a default is to occur.

Fortunately, bond defaults as a whole are still quite rare. In 2017, for example, Standard & Poor's noted only 20 defaults of U.S. public finance bonds. Eighteen of those bonds were non-housing bonds rated below investment grade at the time of default, while two were housing bonds rated B- at the time of default.

Controversy Over Bond Ratings

Ever since the financial crisis of 2008, investors and the general public at large have been more skeptical of bond ratings. Rating agencies were handed a lot of blame for not recognizing the risks involved in certain types of bonds, especially mortgage-backed securities. Many of these bonds were rated AAA right up until the point where they started to crater in value. Although the rating agencies did not cause the financial crisis of 2008, they certainly played a role in reassuring investors of the quality of bonds that ultimately were proven to be worthless.

That the rating agencies could be seemingly blindsided by the shaky financial foundation of so many bonds was an enormous surprise. Many critics complained that there was no way the rating agencies could be independent and objective when bond issuers were paying them to rate their bonds. As a result, a cloud still remains over the agencies and the ratings they assign to bonds. However, the average investor has neither the time or the inclination to study the financial details of individual bond issues, leaving the rating agencies as the most reliable source of information available.

Using Bond Ratings

Bond ratings are meant to be used as a guide to the financial strength of a bond issuer. However, their existence doesn't mean that investors no longer have to perform due diligence when they evaluate an investment. The rating agencies have no legal liability to investors in the event they miscategorize a bond that later defaults, as was proven during the 2008 financial crisis. That being said, bond ratings are a good general indication of the relative safety of a bond, particularly those that are rated triple-A.