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How Bonds Rating Are Determined?

Is my bond safe? Credit agencies are determined your bond risk according to different parameters. What is bond rating and how does it work?
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How Bonds Rating Are Determined?

Have you ever found yourself afraid of a company bankruptcy?

If you were a bond investor, you'd want an assurance that the bond issuer would pay you back later.  The bond issuer should be able to pay the principal and interests in total and on schedule. As an investor, this would be your primary consideration.

There are three major companies that rate bonds for their credit quality. The ‘big three' are: Standard & Poor's (S&P), Moody's Investors Service (Moody's) and Fitch Ratings.  It is important to check a bond's rating before you actually buy it.  It is wise, it is smart and now, it is very simple.  We bet your financial adviser will tell you the same thing.

Credit Rating – How It Works

Bonds are considered ‘investment grade' if they are rated BBB or higher by S&P and Fitch Ratings.  This is also trying for bonds rated BAA or higher by Moody's.  This means that these securities are of high quality and therefore, worth buying.

The credit ratings of the issuer do a lot to the bond:

First, they determine the initial yield of the bond. Next, if the credit ratings change, it will affect the price of the bond in the secondary market.  In many cases, they downgrade the issuer's credit ratings resulting in the price reduction of the bonds.  This commonly happens when the issuer is doing a leveraged buyout.

This means that the issuer is buying a company using the money from the bonds to pay for it. The resulting high debt from such acquisition often brings down the bond's rating, sometimes making it nearly worthless.

Credit Rating Agencies

The SEC selected only a handful of credit rating agencies as nationally recognized statistical rating organizations (NRSRO). These organizations issue credit ratings that the SEC and other firms use for regulatory purposes.

The five major NRSRO's are:

  • Standard & Poor's (S&P)
  • Moody's Investors Service (Moody's)
  • Fitch Rating (Fitch)
  • M. Best Company (A.M. Best)
  • Dominion Bond Rating Service (DBRS)

Credit Rating Ranges

S&P uses a rating that ranges from AAA (highest quality bonds) to D (bonds in default). Moody's implements a slightly different system where Aaa is the highest (minimum credit risk) and C is the lowest, usually for bonds in default.  The other rating agencies have adopted a similar rating scale.

Some ratings add a plus or minus sign after the letters to denote a finer grade distinction. In addition, they may include a code to indicate that the issuer is presently under review.  This means that the rating may change soon.

The Investment Grade

Bonds that receive a rating of BBB or higher from S&P and Baa or above by Moody are good. Investors consider them investment grade. On the other hand, they consider bonds that receive lower ratings as a speculative grade.  These bonds usually pay higher interest rates for the higher risk of loss.

Hence, they generally describe them as high-yield bonds. They consider bonds that receive a rating of C or below as junk bonds because of their high risk of default. Like low-grade bonds, they also pay high-interest rates.  Financial institutions are often limited to buying only investment grade bonds.

For the risk-takers, such securities are attractive because of the higher returns. For the less adventurous but still want to venture into bonds, there is another option. They can buy high-yield bond mutual fund to spread the risk over many issues.

Junk Bonds And Credit Rating

Before 1977, when junk bonds were issued, they initially received a higher rating then eventually degraded due to financial difficulties. In 1977, an investment company changed the system and began the era of original issue junk bonds. The firm Drexel Burnham Lambert and its star trader Michael Milken issued junk bonds in their original speculative state. Companies that would not be able to get an investment grade rating mostly issued these bonds.

These companies chose to bear the higher cost of the bonds because borrowing from the bank was more expensive.

These bonds became popular in the 80's as a means to finance leveraged buyouts and hostile take over attempts.  Today, more companies usually finance leveraged buyouts by issuing bonds. The increase in the supply of investors' money has narrowed the yield gap between junk bonds and quality ones.  This has led to the rise in the practice of using junk bonds for leveraged buyouts.

Are My Bonds At Risk?

Recently, many companies have applied modern corporate management theories in an attempt to increase shareholder value.  As such, we have seen the surge in leveraged buyouts, restructurings, mergers, and recapitalization.  These events can shove the values of the bonds down because of the increase in the company's debt load. These depressions often occur abruptly.  Some issuers have issued bondholder protections but they are not mandatory and they are not sure-fire.

An event risk exempts no bonds – every bond is susceptible. Before you buy a bond, check if the rating agencies have provided a commentary about the issuer's vulnerability.

Credit Rating – How To Read It

When you look at credit ratings, understand that they indicate relative risks and not absolute risks. For example, an issuer with a rating of AA is less likely to default than one rated B.  However, there is no way to tell of their absolute risk. An investor can use past default rates as a guide but keep in mind that things can always change. The past statistics, good or bad, may not be the same as the future performance of companies.

The credit rating can also be totally wrong, especially when the company has fraudulently altered its accounting records.  This was the case with Enron and WorldCom.  They both had investment grade ratings either up to or close to the time they declared bankruptcy. WorldCom had an outstanding $12 billion worth of investment grade bonds a year before they revealed they were bankrupt.

People who bought these bonds lost some 80% of their money.

Credit Rating Agencies in the 2008 Recession

Many people believe that the rating agencies contributed significantly to the 2008 recession.  The investment world would learn years after 2008 that the rating agencies accepted payment for higher ratings.  This practice naturally gave the bonds padded ratings and increased their value, albeit deceptively.  One prime instance of this destructive policy is the illogical drop of rating of a bond.

Once, Moody's downgraded 83% of $869 billion in mortgage-backed securities – they were rated AAA a year before.

Bottom Line

In summary, long-term investors should remember the simple guides in bond investing.  You should carry most of your bond exposure in reliable bonds with good returns.  You should opt for investment grade bonds.  If you're a distressed investor or a speculator, you may turn to high-risk non-investment grade bonds for a higher yield.