Factors of Bond Ratings & Their Implications

by Vicki A. Benge

The U.S. Securities and Exchange Commission refers to the main credit rating agencies in the United States as nationally recognized statistical rating organizations (NRSROs). These independent agencies assign ratings to governments and corporations. The big three used in the United States are Fitch Ratings, Moody's Investors Service and Standard & Poor's Corporation. Each rating agency grades bonds based on a number of financial factors.

Agency Opinions

As the SEC points out, the credit rating is basically an opinion of the rating agency on the creditworthiness of the business or security the agency is grading. Bond ratings ultimately forecast the probability of default. High-quality bonds, referred to as investment-grade bonds, are assigned the highest grades by the major bond rating agencies. For example, Standard & Poor's and Fitch Ratings assign a top grade of AAA. Moody's Investors Service ranks the best quality bonds as Aaa.

Grading Systems

A lower grade on a bond implies higher risk, just as a higher grade implies lower risk. However, the major agencies do not rate bonds the same for every issuer, resulting in a slight variance among the grades assigned. S&P's investment grade bonds carry ratings from AAA, AA, A, BBB, BB, and B. Speculative or junk bonds begin at the grades of BB and lower in S&P's system. Moody's speculative grades begin at Ba, and go lower. Speculative bonds generally pay higher yields than investment grade bonds and are often called simply "high yield bonds." This high yield implies high risk and the higher yield is necessary to entice investors into taking a chance on the riskier products. Higher grade bonds, in turn, generally cost more, thus paying less in return.

Industry Analysis

According to Fitch Ratings, a leader in industry, the agency gathers a variety of information for analyses before assigning and publishing evaluations of creditworthiness. Ratings are assigned based on the financial strength of the issuer. For corporate bonds, factors determining ratings include not only the financial condition of the company, but of the industry in which the company does business. For example, in rating a pharmaceutical company, the rating agencies will consider the economic outlook of the pharmaceutical industry as a whole, just as when assigning a rating to a bond issue of an energy company, the agency will assess the specific energy sector in which the company operates. Future forecasts and implications for specific industries then contribute to the final rating of the bond issue.

Government Bonds

Government-issued debt obligations are rated based on the relative strength the issuer holds in comparison to similar issuers. For example, Moody's Investors Service states that the agency bases the ratings of municipal bonds on five factors: market position, financial position, debt levels, governance and covenants. The bond rating is then assigned based on how the municipality compares to other tax-exempt bond issuers and municipalities based on the same factors.

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