How Bond Ratings Work
Each of the three biggest agencies have their own unique scales to measure the credit quality of a company and its individual bond issues.
Bond ratings are assigned based on a number of factors including:
- Economic sensitivity – How sensitive is the company's financial position to a weakening or improving economy? This often defines the upper limit for bond ratings. Long-lived restaurants like McDonald's can warrant a high rating, but speculative business development companies will never get much more than a BBB rating because of their sensitivity to the economy.
- Interest coverage ratios – Can the company continue to cover interest payments on its bonds given various “stress test” environments? Interest coverage ratios are by far the most important measure as they show just how risky the bond is if a company or governments revenues decline.
- Covenants – How strong are the covenants on the bond issue? Do the covenants keep the company from making poor capital allocation decisions that risk the bondholders' investment?
- Seniority – Some bonds are paid before others in the event the company runs out of cash. Does the bond run the risk of going into default given that it is higher or lower on the totem pole?
- Recoverability – If the worst were to happen and the company, government, or organization issuing the bonds to go into default, does the company have liquid assets to repay the bondholders? Google has a great bond rating because it's debt is so small relative to its total equity, and at any time it could repay its outstanding debt in full just with extra cash it has overseas.
Here's a chart of bond ratings from the three major agencies with cut-offs that bond investors would use:
The best companies, governments, and organizations as a whole get AAA ratings. The worst – those that have stopped paying on their bonds – get a C rating from Moody's and a D from Standard & Poor's and Fitch.
As you know, returns go up with risk. Bonds that have high ratings provide lower yields than bonds with low ratings.
Why Bond Ratings Matter
Whereas there are literally hundreds of brokers rating individual stocks, there are only three major bond ratings agencies that cover the entire bond market. Bond ratings affect:
- Who can invest in a bond – Pension funds have a requirement to hold investment-grade debt or better, for example. When a bond moves into investment-grade ratings, it draws buyers from a much larger pool. When a bond falls into junk bond or non-investment grade ratings, it can only find financing from investors willing to invest in speculative-grade investments (a much smaller pool of investors.)
- The price and yield of a bond – Higher-quality bonds may trade at a premium to face value and offer yields substantially lower than bonds that are not investment-grade. Price and yield are inversely related in the bond market.
- The value of the stock – Peter Lynch always said that if you want to know what the market thinks of a stock, look at how its bonds are trading. Academically speaking, better bond ratings should lead to falling bond yields and higher stock prices, as they are all related in capital asset pricing models.
Bond ratings matter just as much for stock investors as they do bond investors. Ratings are important for passive investors, as well.
Before you invest in any mutual fund or exchange-traded fund, check the prospectus for information on the types of securities it will own. The iShares iBoxx High Yield Corporate Bond ETF (HYG) holds vastly different bonds than the Vanguard Total Bond Market ETF (BND), thus the returns and risks of these two funds are very different.
Understanding what the ratings system means is just one more way to make better decisions about where to allocate your investment dollars.