Why Are Bond Ratings So Important?

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Every bond is rated by at least one bond rating company. A bond rating gives investors important information about a bond and its issuer and allows investors to make an informed decision when deciding whether or not to buy a bond. Bond ratings have become essential tools that investors rely upon when analyzing bonds.

Who Rates Bonds?

  • Standard and Poor's, Moody's, and Fitch are the three major bond rating companies. When a company or a municipality is in the process of issuing a bond they hire one or a number of the bond rating companies to rate the bonds. Investors would be unwilling to invest in a bond if a bond rating company did not rate it.

What is a Bond Rating?

  • After being hired by the company or municipality to rate a bond, the bond rating company evaluates the financial condition of the company or municipality as well as the structure of the bond. They determine the issuer's ability to pay the interest payments and their ability to repay the face value of the bond when the bond matures. Based on this analysis the bond rating company issues a rating. Each of the three main bond rating companies has its own rating system.

Analyzing a Bond's Safety

  • Investors rely on bond ratings to determine the safety of a bond. Individual investors, and even many institutional investors, do not have the resources or expertise to perform the analysis needed to determine the safety of a bond. Bond ratings give investors a way to easily and quickly determine the safety of a bond and the credit worthiness of the issuer.

Determining Interest Rates

  • Since investors rely on the ratings to determine the quality of bonds, the yield that a bond pays bondholders is determined by the bond's rating. Bonds that are rated higher usually have lower yields and interest rates. Lower rated bonds have higher yields and interest rates. The reason behind the relationship between a bond's rating and its yield is that investors demand higher compensation when they take on a higher level of risk when investing in lower quality bonds.

Warning

  • Many people in the financial community are becoming wary of the relationship between bond issuers and the bond rating companies. They believe that there may be a conflict of interest because the bond issuers pay the rating companies a fee to rate their bonds. As a matter of fact, some regulatory agencies are beginning to look into this possible conflict of interest to determine in bond ratings are affected by the payment that the rating companies receive from the issuers. Investors must be aware of the relationship between the issuers and rating companies when researching a bond investment.

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