How Are Bond Ratings Determined?

A bond rating can help assess whether or not your bond will pay off.
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Bond ratings are a way to help you understand the financial risk in a particular bond issue. Not all bonds have ratings, but many do. Bond issuers pay third-party rating agencies, such as Standard & Poor's, to make objective assessments of the risk in a bond and to convey that in an understandable way to investors. While not foolproof, bond ratings provide an important bit of information for investors purchasing bonds.

Financial Health

A bond rating is primarily based on the financial health of the issuer. Ratings agencies base their opinions on a number of financial metrics, just like a bank would if you asked to borrow money. Factors that go into the financial health analysis of a bond include the amount of income a borrower has to pay off the bond and the currency in which the bond is issued. Any collateral used as a basis of repayment for the bond is also reviewed. Ratings agencies also consider the willingness of an issuer to pay off the obligation.

Capital Structure

Just because one type of bond receives a high rating doesn't mean all the bonds a company issues will. Different types of bonds may have higher or lower ratings based on their seniority in the capital structure. If a company encounters financial difficulty, securities at the bottom are only paid after those at the top and therefore may carry lower ratings. Senior secured debt, or debt backed by specific assets, is the first to get paid and typically receives the highest bond rating. Most bonds are not backed by specific collateral and are referred to as "unsecured, " ranking below secured debt. Unsecured debt can be senior or junior, with senior debt having higher repayment priority and a potentially higher rating.

Bond Rating Scale

The three main bond ratings agencies are Standard & Poor's, Moody's and Fitch. Each agency provides 10 main ratings classifications for bonds, although these may be modified upwards or downwards in smaller steps. The top four ratings categories are considered "investment grade," or higher-rated bonds, while the remaining categories are "non-investment grade." For Standard & Poor's and Fitch, investment grade bonds are rated AAA, AA, A or BBB, from high to low. Moody's uses a slightly different system, rating investment grade bonds Aaa, Aa, A or Baa. Non-investment-grade bonds are more vulnerable to nonpayment based on economic or financial issues, with lower ratings reflecting a greater likelihood of nonpayment.

Upgrades & Downgrades

Bond ratings are not set in stone. Ratings agencies continually update their analyses of companies and bond issues and may upgrade or downgrade a rating at any time. A bond upgrade often triggers an increase in the value of a bond, since the greater likelihood of repayment has value. Downgrades can similarly drive a bond price down, as investors sell to avoid credit risk.

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