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Bond Ratings

Representations of the creditworthiness of corporate or government bonds

What are Bond Ratings?

Bond ratings are representations of the creditworthiness of corporate or government bonds. The ratings are published by credit rating agencies and provide evaluations of a bond issuer’s financial strength and capacity to repay a bond’s principal and interest according to the contract.

 

Bond Ratings

 

The three private independent rating agencies – S&P, Moody’s, and Fitch – control almost 95% of the market share of the bond rating business. Each rating agency uses its own grading system. However, all rating systems classify the bond investments by quality grade (investment grade/non-investment grade/not rated) and risk (from default to highest quality). Investment grade bonds are safe investments with minimal default risks, but they provide minimal yields. On the other hand, non-investment grade investments are riskier, but they offer a higher yield.

Bond ratings prepared by professional analysts provide institutional and individual investors with a reliable source for making investment decisions.

 

S&P Global Ratings

Standard & Poor’s (S&P) is the oldest credit rating agency and one of the three Nationally Recognized Statistical Rating Organization (NRSRO) accredited by the U.S. Securities and Exchange Commission. The company covers more than one million credit ratings outstanding on government, corporate, structured finance entities, and securities.

S&P issues both long-term and short-term ratings. The main goal of the S&P credit ratings is the assessment of a security’s default probability.

 

RatingDescriptionGrade
AAAExtremely strong capacity to meet financial obligations.Investment
AAVery strong capacity to meet financial obligations.Investment
AStrong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.Investment
BBBAdequate capacity to meet financial commitments, but more subject to adverse economic conditions.Investment
BBLess vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.Speculative
BMore vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.Speculative
CCCCurrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.Speculative
CCHighly vulnerable; default has not yet occurred but is expected to be a virtual certainty.Speculative
CCurrently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.Speculative
DPayment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken.Speculative
NRThe security was not rated.-         

 

Moody’s Investors Service

Moody’s is another credit rating agency accredited by NRSRO. The company covers more than 135 sovereign nations, 5,000 non-financial corporate issuers, 4,000 financial institutions, 18,000 public finance issuers, 11,000 structured finance transactions, and 1,000 infrastructure and project finance issuers. Unlike S&P and Fitch, the primary purpose of Moody’s ratings is the evaluation of projected losses in case of a default.

 

RatingDescriptionGrade
AaaObligations of the highest quality, with minimal risk.Investment
AaObligations of high quality, with very low credit risk.Investment
AObligations of upper-medium-grade, with low credit risk.Investment
BaaObligations of moderate credit risk that may possess speculative characteristics.Investment
BaObligations with speculative elements that are subject to substantial credit risk.Speculative
BObligations are considered speculative that are subject to high credit risk.Speculative
CaaObligations of poor standing and are subject to very high credit risk.Speculative
CaHighly speculative obligations that are likely in, or very near, default, with some prospect of recovery in principal and interest.Speculative
CLowest-rate class of obligations that are typically in default, with little prospect of recovery of principal and interest.Speculative

 

The numerical modifiers can be added to the existing rating categories from Aa to Caa. The number 1 indicates that that the obligation is ranked at the higher end of the rating category, 2 indicates a mid-range ranking, and 3 indicates the lower end of the rating category.

 

Fitch Ratings

Fitch is the smallest credit rating agency among the “Big Three” agencies. The firm covers several different sectors, including financial institutions, insurance, sovereigns, corporate finance, structured finance, Islamic finance, and global infrastructure. However, Fitch’s market share is limited relative to that of its bigger rivals.

Similar to S&P, the main purpose of Fitch’s rating is the assessment of a security’s default probability. It also uses a similar rating scale as S&P.

 

RatingDescriptionGrade
AAAExtremely strong capacity to meet financial obligations.Investment
AAVery strong capacity to meet financial obligations.Investment
AStrong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.Investment
BBBAdequate capacity to meet financial commitments, but more subject to adverse economic conditions.Investment
BBLess vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.Speculative
BMore vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.Speculative
CCCCurrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.Speculative
CCHighly vulnerable; default has not yet occurred but is expected to be a virtual certainty.Speculative
CCurrently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.Speculative
DPayment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken.Speculative
NRThe security was not rated.-         

 

Importance of Credit Ratings

Credit rating agencies play an important role in credit laws and regulations in the United States and a number of European countries. Moreover, rating agencies significantly affect global capital markets by providing an assessment of securities to investors. Credit ratings remain one of the essential sources of information regarding credit analysis and credit risk for investors.

However, investors must not solely rely on the credit ratings provided by credit agencies. The global financial crisis in 2007-2008 proved that the close relationship between credit rating agencies and large financial institutions could cause conflicts of interest. For example, credit rating agencies gave the highest ratings to many mortgage-backed securities that, in reality, were close to the status of junk securities.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To help you advance your career, the additional resources will be helpful:

  • Bond Issuers
  • Equity vs. Fixed Income
  • Fixed Income Glossary
  • Investing: A Beginner’s Guide

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