Bond rating essentials: a beginner’s guide

We look at how agencies such as Standard & Poor's and Moody's rate bonds, and what the ratings mean.

Bond ratings are combinations of letters that theoretically indicate the creditworthiness of a bond issuer and by implication the bonds themselves. The letters are often taken to provide an indication of the likelihood of default. Default is a bond issuer failing to pay interest on a bond on time and in full, or failing to repay capital on the bond’s redemption date.

Ratings are set by credit rating agencies including Standard & Poors, Moody’s, Fitch and others.

There is plenty of data available on the percentage of defaults for each ‘notch’ of the ratings spectrum at extreme low points in the past economic cycles. But default rates vary a lot from year to year so historical data of this sort does not necessarily indicate the probability of default in any true statistical sense.

The premium on which bond yields stand over supposedly tax-free sovereign debt of similar maturity (for example US Treasuries, UK gilts or German bunds) gets higher as one moves down the ratings spectrum.

 

But what do the ratings mean? Here’s a quick summary, although the specifics may change from one ratings agency to another:

  • AAA: capacity to meet obligations is 'very strong'.
  • AA: differs from AAA only slightly.
  • A: more susceptible to changes in conditions; 'strong' rather than 'very strong'.
  • BBB: likely to be affected to changes in condition but protection 'adequate'.
  • BB: uncertainties may mean inadequate capability of meeting commitments.
  • B: uncertainties are likely to impair ability to meet commitments.
  • CCC: vulnerable to non-payment unless conditions improve.
  • CC: highly vulnerable to non-payment.
  • C: currently paying, but default highly likely.
  • D: in default.
  • NR: not rated, or insufficient information.

This is based on S&P ratings. Fitch uses a similar convention. Moody's uses a slightly different convention, mixing upper and lower-case letters and numbers. All three generally convey a similar message. It's also worth remembering that there are sub-divisions within these broad categories that have slightly different meanings.

Bonds are reckoned to be 'investment grade' if they are BBB- (S&P and Fitch) or Baa3 (Moody's) or better. Recent historical data suggests that default rates increase sharply as rating notches decrease below the 'B' grade and are very high for CCC and below. Bonds with ratings in this category had a median default rate of 18 per cent in the 30 years to 2008. The highest percentage default rate for any single year over the same period was 57 per cent and the lowest 0 per cent.

There is a degree of risk in all investments, so it helps to be able to assess how risky an asset is before making an investment decision.

There’s a good chance that most investors will access bonds through a collective investment fund or trust. Funds that invest in bonds will generally publish the credit rating cross-section of the portfolio, allowing investors to make an informed choice – as long as they can wrap their heads around ratings.

Finally, be aware: bond ratings indicate a probability, not a certainty. This means that even investment-grade bonds are not entirely free from default risk: ratings agencies found themselves at the centre of a hurricane of bad press during and after the sub-prime lending debacle. 

However, a good grasp of how bond ratings work can help you assess how risky bond or bond fund might be.

This was written for our sister website, Interactive Investor

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.

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