Bond Ratings and Credit Risk

How much interest a bond has to pay in order to sell is dependent not only on the current prevailing interest rate, but also upon the issuer's credit rating, which is a independent gauge by a credit rating agency of the credit risk of the issuer. Credit risk is the risk that the investor may lose part or all of his investment because of the issuer's insolvency, or inability to pay the interest and principal. The greater the credit risk, the more interest the issuer has to pay to sell its bonds.

The 5 major services that rate bonds are S&P, Moody's, Fitch, A.M. Best, and Dominion Bond Rating Service, and are the 5 nationally recognized statistical rating organizations (NRSRO) selected by the Securities and Exchange Commission. Standard & Poor's ratings range from AAA for the highest quality bonds to D, which are bonds in default. Moody's rating system is slightly different, ranging from Aaa for the highest quality down to the lowest rating of C, which characterizes bonds of little or no value. The other rating agencies have similar ratings. All bonds rated BBB or above by Standard & Poor or Baa or above by Moody is considered investment grade; bonds with lower ratings are considered speculative grade, which pays higher interest rates for the higher risk of loss; thus, these bonds are sometimes referred to as high-yield bonds. Bonds with ratings that begin with C or below are referred to as junk bonds, because of their high risk of default. Junk bonds also pay the highest interest rate. Recently, Moody's has expanded its public ratings of companies that enable a more detailed comparison. Financial institutions and trustees are generally restricted to purchasing investment grade bonds.

Some bonds are not rated because the issuer doesn't want to pay for a rating, or because the issuer does not have a sufficient credit history for a credit rating. Any bond or note that is backed by the U.S. Treasury is not rated because such securities are considered risk-free.

Issuers of municipal bonds can buy insurance for their investors from companies such as AMBAC, FGIC, and MBIA, which will guarantee payment in case of default. Such bonds generally receive the highest ratings from the credit rating services.

Investor Alert! Note that credit ratings are not foolproof. Enron had an investment-grade rating right up until it declared bankruptcy, and WorldCom up to 3 months before filing for bankruptcy!

It's also a good idea to check all of the credit-rating agencies about a particular issuer, because different agencies have different criteria, and different strengths and weaknesses in rating bond issuers.

Seach this financial encyclopedia by using the search engine below.

Custom Search

◄ Share or bookmark this page on several major sites.

Information is provided 'as is' and solely for education, not for trading purposes or professional advice.