Bond Credit Ratings – What They are and How they Work
Bond credit ratings are the equivalent to an individual’s credit score and are designed to guage the risk that a bondholder will not receive a portion or all of the interest and principal payments they are due on a bond.
Different borrowers (bond issuers) are going to have different abilities to repay their debt.
The US government is considered to have a very low risk of not being able to re-pay debt, and therefor has a very good credit rating. To raise cash to re-pay debt, the US government has several tools at its disposal:
- Tax its constituents (both individuals and corporations)
- Issue more bonds
- Sell assets such as government buildings
- Print money
Corporations generally have a lower credit rating than the US government.
Corporations, for example the Ford Motor Company, have the following tools to re-pay debt:
- If profitable, they can generate cash to pay the debt
- Borrow funds from banks or issue more debt
- Sell assets. They do not have the power to tax or print money.
With this in mind, it stands to reason that people are going to feel more comfortable, and therefore demand a lower interest rate, when investing in US Treasuries than they are when investing in the Ford Motor company. This is where bond credit ratings come into play.
If a corporation or government has multiple bond issues, they will often have different credit ratings. In the case of bankruptcy there there is an order in which bonds get re-paid.
Those bond issues that get paid first will have a higher credit rating.
Bond Credit Ratings Agencies
As there are literally millions of different types of bond issues out there, a standardized system is needed in order to know what the credit quality is of one bond vs. another. This is where the ratings agencies, or those companies that are tasked with classifying the credit worthiness via bond credit ratings come into play.
- Standard and Poor’s (S&P)
Based on the ratings for these companies, bond issues are put into two broad categories:
Investment Grade / High Grade Bond Credit Ratings
Bonds that have a high credit worthiness and a relatively low chance of defaulting on part or all of their debt.
Junk Bonds / Low-Grade / High Yield Bonds Bond Credit Ratings
These bonds are considered risky investments and tend to pay higher interest rates than Investment grade debt.
Lets move onto discussing the actual ratings issued by the Moody’s, S&P, and Fitch. Now I wish I could tell you that these fine institutions chose a simple and easy to understand rating system for telling a high quality bond from low quality bond, but unfortunately this is not the case. Not only are the bond credit ratings they put out complicated to understand, but they each have their own system.
To help simplify things for us, lets look at the below outlines from Wikipedia
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