Bond Credit Ratings
When corporations and governments issue bonds, they typically receive a credit rating on the creditworthiness of the debt from each of the three major rating agencies: Standard & Poor’s, Moody’s, and Fitch.
These ratings incorporate a variety of factors, such as the strength of the issuer’s finances and its future prospects, and they allow investors to understand how likely a bond is to default or fail to make its interest and principal payments on time.
The bond rating agencies look at specific factors including:
The strength of the issuer’s balance sheet. For a corporation, this would include the strength of its cash position and its total debt. For countries, it includes their total level of debt, debt- to-GDP ratio, and the size and directional movement of their budget deficits.
The issuer's ability to make its debt payments with the cash left over after expenses are subtracted from revenue.
The condition of the issuer's operations. For a corporation, ratings are based on current business conditions including profit margins and earnings growth, while government issuers are rated in part based on the strength of their economies.
The future economic outlook for the issuer, including the potential impact of changes to its regulatory environment, industry, ability to withstand economic adversity, tax burden, etc., or in the case of a country, its growth outlook and political environment.
Standard & Poor’s ranks bonds by placing them in 22 categories, from AAA to D. Fitch largely matches these bond credit ratings, whereas Moody’s employs a different naming convention.
In general, the lower the rating, the higher the yield since investors need to be compensated for the added risk. Also, the more highly rated a bond the less likely it is to default.
Interpreting the Ratings
A high rating doesn’t remove other risks from the equation, particularly interest rate risk. As a result, it can provide information about the issuer but can’t necessarily be used to predict how a bond will perform. However, bonds tend to rise in price when their credit ratings are upgraded and fall in price when the rating is downgraded.
How much do ratings really mean? While they provide a general guide, they shouldn't be relied upon too closely. Consider this quote from Peritus Asset Management's whitepaper, The New Case for High Yield, published in April 2012:
"Investors should understand what the rating agencies themselves say about their ratings. Among their various disclosures, the rating agencies caution that their ratings are opinions and are not to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security.
So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 25+ years. We see the rating agencies as reactive, not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions."
Bond Credit Rating Categories
With the above warning in mind, here’s an explanation of the bond credit rating categories used by S&P, with the equivalent Moody’s ratings parentheses:
AAA (Aaa): This is the highest rating, signaling an “extremely strong capacity to meet financial commitments,” in the words of S&P. The U.S. government is given this top rating by Fitch and Moody’s, while S&P rates its debt a notch lower. Four U.S. corporations, Microsoft, Exxon Mobil, Automated Data Processing, and Johnson & Johnson, have AAA ratings, while S&P ranked 10 of 59 countries AAA as of October 2017.
AA+, AA, AA- (Aa1, Aa2, Aa3): This rating category indicates that the issuer has a “very strong capacity to meet its financial commitments.” The differences from AAA are very small, and it’s very rare that bonds in these credit tiers will default.
From 1981 through 2010, only 1.3 percent of global corporate bonds originally rated AA eventually went into default. Note that bonds usually experience rating downgrades prior to actual default.
A+, A, A- (A1, A2, A3): S&P says about this category: “Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.” In other words, while Microsoft or an AAA-rated government issuer could withstand a prolonged recession without losing the ability to make its debt payments, this is somewhat more in question when it comes to securities in the “A” category.
BBB+, BBB, BBB- (Baa1, Baa2, Baa3): These bonds have “adequate capacity to meet financial commitments, but are more subject to adverse economic conditions or changing circumstances.” A step down from the A rating tier, BBB- is the last tier at which a bond is still considered “investment grade.” Bonds rated below this level are considered “below investment grade” or, more commonly, “high yield,” a more risky segment of the market.
BB+, BB, BB- (Ba1, Ba2, Ba3): This is the highest rating tier within the high yield category, but a BB rating indicates a higher level of concern that deteriorating economic conditions and/or company-specific developments could hinder the issuer’s ability to meet its obligations.
B+, B, B- (B1, B2, B3): B-rated bonds can meet their current financial commitments, but their future outlook is more vulnerable to adverse developments. This helps illustrate that credit ratings take into account not just current conditions, but also the future outlook.
CCC+, CCC, CCC- (Caa1, Caa2, Caa3): Bonds in this tier are vulnerable right now and, in S&P’s words, are “dependent on favorable business, financial and economic conditions to meet financial commitments”. Fitch uses a single CCC rating, without breaking it out into the plus and minus distinctions as S&P does.
CC (Ca): Like bonds rated CCC, bonds in this tier are also vulnerable right now but face an even higher level of uncertainty.
C: C-rated bonds are considered most vulnerable to default. Often, this category is reserved for bonds in special situations, such as those in which the issuer is in bankruptcy but payments are continuing at present.
D (C): The worst rating, assigned to bonds that are already in default.
The Changing Landscape
In recent years, large companies have been more willing to embrace debt as part of an effort to increase perceived value by shareholders. In 1992, 98 U.S. companies held an AAA credit rating from Standard & Poor's. By 2016, only two companies had retained their AAA rating.