Bonds are ranked on the basis of the degree of risk associated with timely payment of their interest and principle. A bond rating is a grade given to a bond that indicates its credit quality. Private independent rating services provide these evaluations of a bond issuer’s financial strength or its ability to pay a bonds principal and interest in a timely fashion.
Most bonds carry a rating that is provided by one of the three independent rating agencies: Standard & Poor’s, Moody’s and Fitch.
Bond rating agencies (such as Standard & Poor’s) use a grading system as follows:
- AAA: highest quality (called ‘gilt edged’)
- AA: high quality
- A: Upper medium grade
- BBB: medium grade
- BB: has speculative elements
- B : speculative
- CCC : speculative with possibility of default
- CC : most speculative
- C : lowest gradable quality
- DDD: In default with possibility of recovery.
- DD : In default and arrears
- D: In default, with little or no value.
Bonds rated “BBB” or higher are considered investment grade suitable for financial institutions with fiduciary responsibilities. Bonds rated below ‘B’ are considered speculative grade and are called high yield or junk bonds which, due to greater likelihood of their, must pay higher interest rates to attract investors.
The bond rating is an important process because the rating alerts investors to the quality and stability of the bond. That is, the rating greatly influences interest rates, investment appetite and bond pricing. Furthermore, the independent rating agencies issue ratings based on future expectations and outlook.