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Understanding Bond Ratings

Understanding Bond RatingsWhat are Bond Ratings?

Bond ratings are grades that are given to bonds to indicate the instrument’s credit quality, meaning their ability to fulfill their obligation to the underlying investor. Bond ratings are given to all types of bands and are supplied by independent rating services such as Moody’s and Fitch and Standard & Poor’s. These companies provide grades to all classes and forms of bonds based on the instrument’s strength and its ability to pay the attached principal and interest in accordance with the maturity schedule.

Bond ratings are analogous to credit ratings for individuals; those bonds that possess a higher rating are valued at a higher rate and viewed as safe investments when compared to bonds with lower ratings.

Credit Rating Agencies:

Credit rating agencies must be registered and labeled as such with the Securities and Exchange Commission. When they are registered, they are labeled as “Nationally Recognized Statistical Rating Organizations.” This status enables these agencies to evaluate the worthiness of bonds and attach their evaluations with an affirmed credit rating. 

According to the Credit Rating Agency Reform Act, a Nationally Recognized Statistical Rating Organization may be registered with respect to up to five distinct classes of credit ratings: 1.0 brokers, dealers and financial institutions; 2.) insurance companies; 4.) issuers of asset-backed securities; 3.) corporate issuers; and 5) issuers of municipal securities, government securities, or securities that are issued by a foreign government.

Credit Rating Tiers:

Bond Rating    Standard & Poor’s    Moody’s
Highest Quality Bonds    AAA    Aaa
High Quality Bonds    AA    Aa
Upper Medium Quality Bonds    A    A
Medium Quality Bonds    BBB    Baa
Somewhat Speculative Bonds    BB    Ba
Low Grade, Speculative Bonds    B    B
Low Grade, Possibility of Default    CCC    Caa
Low Grade, Partial Recovery Possible    CC    Ca
Default, Recovery Unlikely    C    C

The above graph demonstrates the rating system incorporated by the two dominant rating agencies in the United States. The grades are given based on the bond’s credit worthiness and the expected ability of the bond to be repaid in full plus the attached interest payments. Bond ratings are the measure of the quality and security of the underlying bond and are primarily based on the underlying financial condition of the issuer.

In a more specific sense, bond ratings incorporate an evaluation from one of the recognized rating services to indicate the likelihood that a debt issuer will be able to meet the scheduled interest and principal repayments to the investor. Typically, those bonds that are graded as ‘D’ bonds are the lowest quality bonds and are already in default.