What are bond ratings and how do they help bond investors?

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There are three main risks that investors face when investing in bonds: interest rate risk (the risk that interest rates could rise), purchasing power risk (the risk that inflation will rise and thereby erode the value of bonds), and credit risk (the risk that a bond issuer will become unable to meet its debt obligations).� While assessing the first two risks demands that individual investors conduct a significant amount of research on their own, credit risks are arguably the easiest for investors to assess�thanks to credit ratings.�

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Credit ratings are essentially rankings of a company�s ability to repay their debts and to withstand various types of financial and economic stress compared to that of other companies.� Ratings are intended to help provide forward-looking opinions on a company�s ability and willingness to pay interest and repay principle as scheduled.� (For purposes of simplification, this article will discuss ratings as they apply to corporations.� Keep in mind that the same general principles apply to government debt, municipal debt, agencies, and other fixed income securities).

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The Rating Agencies

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There are several private companies that issue credit ratings, the most prominent of which are: Moody�s Investor Services, Standard & Poors, Fitch IBCA, and Duff & Phelps.� Each of these rating agencies follows a very thorough and rigorous methodology for determining a company�s creditworthiness.� While the rating that each of these agencies assigns to a particular company can sometimes vary, for the most part their assessments are not usually far apart.

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The most prominent and oldest of the rating agencies is Moody�s.� It all began in 1909 when founder John Moody introduced a simple grading system for railroad bonds.� Soon enough, Moody�s methodology was being applied to other industries and the ratings system was underway.� Moody�s current broad reach extends to roughly 1,500 issuers and some $2 trillion of bonds rated in the Aaa to Baa grades (more on these symbols later).� Moody�s has ratings on 90% of public market bonds.

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For anyone that can cite the alphabet, the ratings system is actually quite simple to learn.� All of the rating agencies use the letters A through D to signify a decreasing level of credit worthiness.�

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There are two main categories of investments within the A through D grades�investment grade and below-investment-grade.� Investment grade bonds are believed to have a low probability of default whereas below-investment-grade bonds are thought to have a relatively greater probability of default.�

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Below is a simplified table detailing the ratings used y the major rating agencies:

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CREDIT RATINGS
Credit Risk	Moody's*	Standard & Poor's*	Fitch IBCA**	Duff & Phelps**
INVESTMENT GRADE
Highest quality	Aaa	AAA	AAA	AAA
High quality (very strong)	Aa	AA	AA	AA
Upper medium grade (strong)	A	A	A	A
Medium grade	Baa	BBB	BBB	BBB
NOT INVESTMENT GRADE
Lower medium grade (somewhat speculative)	Ba	BB	BB	BB
Low grade (speculative)	B	B	B	B
Poor quality (may default)	Caa	CCC	CCC	CCC
Most speculative	Ca	CC	CC	CC
No interest being paid or bankruptcy petition filed	C	C	C	C
In default	C	D	D	D

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Note that only Moody�s uses a lower case letter in their ratings system.� In addition, they often attach a number to their letter ratings as well.� They do this to give their ratings assignment greater specificity with regard to rank and to avoid generalizations within ratings categories.�� Here is how Moody�s describes the use of numbers within ratings grades: �Moody's applies numerical modifiers 1, 2, and 3 in each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.�� Basically, the numerical modifiers that Moody�s uses increases the number of ratings grades that they can assign.� This gives investors still-more information to gauge the creditworthiness of the companies that they analyze.

The Ratings Categories�Investment Grade

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The most familiar of the credit ratings is, of course, triple-A.� Triple-A rated bonds are deemed to be of the highest credit quality.� Companies that obtain a triple-A rating have the highest capacity to meet its financial commitments.� Triple-A rated bonds are deemed protected by a �large and exceptionally stable margin and principal is secure,� according to Moody�s.� While triple-A rated companies are, as with all companies, subject to potential changes in their outlook, the changes are felt �unlikely to impair the fundamentally strong position� of these companies.

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Examples of companies that carry the prestigious triple-A rating include companies with strong

balance sheets in industries that are generally not subject to the extremes of the business cycle.� Companies such as General Electric, Exxon, the United Parcel Service, Merck, and Johnson & Johnson carry a triple-A rating on their debt.

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Double-A rated bonds �differ from the highest-rated obligations only in small degree,� according to �Standard & Poor�s.�� Companies that carry a double-A rating are believed to have a very strong capacity to meet its financial obligations.� Here is how Moody�s characterizes double-A bonds: �Bonds which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities.�

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The double-A rating is applied to a diverse group of elite companies from a broad array of industries.� Companies that carry a double-A rating include AT & T, Proctor & Gamble, Kimberly Clark, Motorola, JP Morgan, Dupont, and Eli Lilly.

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Beyond the two high-grade ratings categories, triple-A and double-A, the creditworthiness of companies with lower ratings begins to deteriorate slowly but surely.� Single-A rated bonds, for example, are considered �susceptible� to changing business and economic conditions and their ability to repay their debts is considered merely �adequate.�� Thus, investment in single-A rated bonds carries a somewhat higher degree of risk than the high-grade categories do.�

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Examples of bonds carrying the single-A designation include bonds of companies with somewhat greater sensitivity to cyclical economic conditions than companies rated triple- and double-A rated ratings.� These include the consumer cyclical companies such as retailers and automobile companies.� Financial companies are also often in this category because their profits and potential losses (from loan losses, bankruptcies, and the like) can vary sharply with the ups and downs of the business cycle.�

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Below Investment-Grade

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The final ratings category considered investment-grade is triple-B.� Bonds in this category are basically on the borderline between investment- and speculative-grade debt.� As Moody�s puts it, they are �neither highly protected nor poorly secured.�� Triple-B bonds are felt to have less protective elements than higher rated bonds and are considered vulnerable to potential changes in both an obligor�s company business fundamentals as well as the economic environment.� Companies in this category are therefore likely to have a weakened capacity to repay its debts under changed circumstances.

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Beyond the triple-A to triple-B range, obligations rated BB, B, CCC, CC, and C are regarded as having significant speculative characteristics with BB indicating the least degree of speculation and C the highest.� But companies carrying below investment-grade ratings are not necessarily outright speculative investments.� Indeed, many of them have at least some quality and protective characteristics, even if they are outweighed by many uncertainties and vulnerabilities.

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How Credit Ratings Affect a Bond�s Yield

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The ratings designation on a bond has a significant bearing upon its yield-to maturity.� Triple-A rated bonds for example, will have a much lower yield compared to that of triple-B bonds.� In recent years triple-A bonds have averaged a yield of *** basis points over U.S. Treasuries. In contrast, triple-B bonds have averaged a yield of *** basis points over Treasuries.� High-yield bonds, also known as junk bonds, have averaged a yield of roughly *** basis points over the same time period.

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But just because certain bonds with the same maturity share the same ratings designation doesn�t necessarily mean that their yields will be the same, too.� Indeed, for a variety of reasons, two companies with identical ratings and maturity dates could have much different ratings.� Factors that could cause similarly rated bonds to differ in yield include: industry fundamentals and characteristics such as the extent to which one company�s bonds are more or less vulnerable to the ups and downs of the business cycle; the total amount of debt that a company owes; an agencies opinion about a company�s management; cash flows; and exposure to various risks including regulations, and international conditions.

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Methodology

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The rating agencies conduct a very thorough review of the companies that they rate.� There are numerous considerations that are weighed, the most important of which is a company�s cash flow.� Basically, if a company is a cash cow, it is very likely to have a high credit rating.� Rating companies look closely at the source of a company�s cash flow as well as its variety, availability, and source.� Companies with high credit ratings have quick-turning, high quality accounts receivable, meaning that they are getting paid on time and getting all that they are due.� Rating agencies also consider it important that a company have the ability to sustain their profitabaility..

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Aside from cash flows, rating agencies scrutinize a company�s management for their competence, structure, strategic planning, and composition.� Other considerations include scrutiny of a company�s appetite for risk and competition.

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Scrutiny of a company�s cash flows and their overall balance sheet requires a significant amount of mathematical homework.� Rating agencies therefore deploy dozens of mathematical formulas and financial ratios to aid them in their rigorous examinations.� The ratios are used for gaining an understanding of the financial characteristics of a firm.� But rating agencies take pains to meld both quantitative and qualitative analyses in order to get the most complete picture of a company.

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Rating agencies must always consider external factors such as the economic cycle but the fundamentals of the companies that they rate always get first consideration and have a far greater bearing on a company�s overall rating.� Nevertheless, rating agencies have increased their responsiveness to and consideration of the economic cycle in recent years given the large impact that the economic cycle has on many companies.

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Credit Ratings: A Must-Have For Every Fixed Income Toolbox

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As you can see, rating agencies supply an enormous amount of information to help investors in the investment decision-making process.� Investors are fortunate to have the complex and thorough research of the rating agencies summarized for them with a few simple ratings grades. Investors need simply gain an understanding of the various ratings grades to begin using ratings in their arsenal of research tools.� Of course, investors should do a bit of research of their own, too, but it�s comforting to know the rating agencies have done a good deal of work for us.