How Important Are Bond Ratings When Evaluating a Bond for Purchase?

by W D Adkins, Demand Media
    Bond ratings tell you how creditworthy the bond issuer is.

    Bond ratings tell you how creditworthy the bond issuer is.

    Bonds represent borrowed money. When you purchase a bond, you become a lender. The bond issuer is supposed to pay you interest and repay the borrowed money on a scheduled date. Bond ratings are important because they are similar to your own credit score: the bond rating tells you how good the bond issuer’s credit is. When you're being a lender, that’s info you really need.

    Bond Basics

    Bonds are essentially borrowing agreements. The terms of the bond state a face value, which is the amount the bond issuer owes. The bond has to be redeemed, meaning the borrowed money repaid, on a stated date called the maturity. The terms of the bond also state the amount of interest the bond pays each year, called the coupon. The U.S. Treasury and many corporations sell bonds to borrow money, as do state and local governments. Some bonds, called agency bonds, are issued by government-sponsored enterprises, such as the Tennessee Valley Authority.

    Bond Ratings

    Bond issuers have two basic obligations. First, they have to pay the interest due on time, which is usually every six months. The second obligation is to pay off the debt on the maturity date. As an investor, you need to assess the credit risk of a bond before you purchase it, meaning how likely it is that the bond issuer will be able to meet its financial obligations. Bonds are rated based on a number of factors, including the issuer’s financial condition, quality of management, and performance history. In addition to evaluating a particular bond, you can use ratings to compare the risk represented by different bonds.

    Rating Systems

    There are three major bond rating services: Moody’s, Fitch, and Standard & Poor’s. Their rating systems are very similar with slight differences in the labeling. For example, the bonds rated as being strongest or safest are ranked “AAA” and “AA+” by Fitch and S&P, but the same rankings by Moody’s are listed as “Aaa” and “Aa1.” Ratings go all the way down to C and D. Bonds rated at least BBB-, or Ba3 by Moody’s, are considered investment grade. Any lower rating indicates a high-risk or junk bond. Bonds with low ratings typically have to pay more interest to attract investors.

    Considerations

    Bond ratings can change and that affects their value. Ratings services review the bonds they rate and adjust the rating if a bond issuer’s situation changes. Suppose Company A’s bonds are rated BBB, but the firm’s profits and funds available to meet its debt obligations improves. The ratings services may upgrade the bond rating a notch to A. That’s likely to result in an increase in the price of the bond because investors will pay more since their risk has lessened. It sometimes happens that a bond rating is downgraded. In that case you may see the bond price go down as well.

    About the Author

    W D Adkins has been writing professionally for two years. His writing interests include education, business and finance. Adkins is a doctoral student with Masters Degrees in history and sociology from Georgia State University. He is also a member of the Society of Professional Journalists.

    Photo Credits

    • Jupiterimages/Comstock/Getty Images