How Do Bond Ratings Agencies Work?

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17 May 2019
Bonds have their own system of determining if they’ll be paid back. Here is some background about bond ratings agencies and how they work.

In today’s onslaught of information, we get messages regularly about how we should be investing our money. 

Whether to invest in stocks versus bonds is one of the common ones. 

Many of the messages are about stocks, but did you know the U.S. bond market is $41 trillion dollars per year?

If you’re interested in earning a regular income that can be relatively low-risk, keep reading to learn more about bonds and bond ratings.

What Are Bonds and Who Issues Them?

Bonds are a way for entities to raise money. They are also good options for investors looking for a fixed rate of return on their money. 

How do bonds work?  The bond issuer creates a bond by agreeing to repay the principal to their investors in full at a particular time, plus interest. Bond issuers pay interest at a fixed rate and in installments over the life of the bond. 

Bonds can be issued by government entities large and small: individual countries, states, or local municipalities. Corporations can also issue bonds.

The U.S. Securities and Exchange Commission regulates bonds.

Who Rates the Bonds?

Bonds are rated by rating agencies. These agencies get paid by the bond issuer.

Moody’s Investor Service, Standard and Poor‘s Global Ratings and Fitch Ratings are the primary bond rating agencies in the U.S. 

What Are Bond Ratings? 

In order for a bond to be issued, it must be given a rating. 

The rating indicates the agencies opinion regarding how likely the borrower will be able to timely repay the investor their principal and interest payments.

The rating agency also takes into account the financial strength of the bond issuer. 

What are the Different Bond Ratings?

These three bond rating agencies use letters, numbers and/or symbols to rate bonds. The more of the same letter is best, but the addition of a plus (+) sign or a lower number (such as 1 versus 2 or 3) is even better. 

Triple-A Bonds (AAA or Aaa) are the best ratings, but those are just the beginning.

From highest to lowest, Standard & Poor and Fitch use the following ratings: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, CC, C, and D.

Moody’s bond ratings are: Aaa, Aa1, Aa2, AA3, A1, A2, A3, Baa1, Baa2, Baa3Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, and C.

To simplify the above, keep the following terms in mind: investment grade bonds (above in bold) and high-yield bonds (above in italics). 

Investment Grade Bonds

Investment grade bonds are bonds rated between AAA/Aaa and BBB-/Baa3.

These ratings indicate that the rating companies consider the bonds to be low risk. Meaning they have the highest chance to have the principal repaid, interest paid on time and the least likely to default.  

High-Yield Bonds (Junk Bonds)

Bonds with ratings BB+/Ba1 and lower are considered higher risk. 

Because of these poor ratings, the bond issuer has to offer investors increasingly higher rates as the rate gets lower, in order to attract them to invest.  

Get More Information About Bonds Today

To determine if bonds are the right investment for you, bond ratings, your age and your aversion to risk are just a few factors that need to be taken into account. 

Speak to a financial adviser to determine which bonds are best for you and how much of your financial portfolio should be allocated to bonds.

If you would like more information about investing in bonds or bond ratings, please contact us.

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