How Are Bond Ratings Determined?

by Rose Johnson

Ratings for bonds are similar to credit scores given to individuals by credit agencies. Bond ratings for corporations are issued to inform investors of a company's creditworthiness. Investors depend on these ratings to evaluate companies and make investment decisions. Bond ratings are expressed as letters, and usually range from a high of AAA to C. Rating agencies go through a specific process to determine a company's financial health. Understanding how to interpret bonds ratings is an important concept for individuals looking to invest in bonds.

Qualitative Analysis

Rating agencies perform qualitative analysis on a company to determine if it possesses the cash flow needed to repay investors. To perform this analysis, ratings agencies analyze a company’s financial statements and compute financial ratios to determine the liquidity of the company's assets and its cash flow. Liquidity and cash flow deal with a company’s ability to generate cash in the future. Most corporate bonds are long-term investments, and rating agencies want to know if a company can meet its debt obligations in the long-term. Rating agencies also review a company’s investment policies.

Quantitative Analysis

Qualitative factors reviewed by rating agencies include a company’s strategic plans and financial management practices. Strategic planning is an internal process that involves defining the company’s direction and vision, and allocating the necessary resources to bring the strategy into fruition. Ratings agencies look at whether a company implements and follows financial management practices, even when the business is not performing well. Other qualitative factors include a company's disclosure practices, the experience and tenure of its management team, and post-employment benefits offered to employees.

The Process

Once the rating agency performs its qualitative and quantities analysis on a company, it issues a rating based on its finding. Some ratings agencies give first-time applicants the option of whether to make the rating public. Ratings vary per rating agency, but the highest ratings are given to companies deemed financially stable. Ratings agencies give poor ratings to companies they feel will experience a difficult time repaying the principal and interest owed to investors. The interest rate a bond issuer pays to investors is directly rated to the company’s bond rating. The lower the rating, the higher interest the company must pay to attract investors. Companies with high ratings typically pay lower interest rates.

Benefits and Limitations of Bond Ratings

The primary benefit of bond ratings is that investors are given an indication of the interest rate to expect in relation to the risks associated with investing in the bond. When the financial health of a company declines, a rating agency may downgrade the company’s rating. This is an advantage to investors because they are able to make quick investment decisions to reflect the changes in the organization. However, bond ratings also offer some limitations. Bond ratings cannot predict in percentage terms the likelihood a company will default on its obligation. Ratings also fail to show the market value of a bond. Further analysis is needed by investors to determine how much to pay for a bond.

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