The Purpose of Bond Ratings

Often, before a borrower issues a bond, the bond will receive a rating from one or more credit-rating agencies. These ratings act as a measurement of the likelihood that the lender will be able to pay the bond on time and in full. Investors, in turn, can use the ratings to decide whether to purchase certain bonds.

Many institutional investors require that bond issuers rate their bonds with Nationally Recognized Statistical Rating Organizations, or NRSROs, which are registered with the U.S. Securities and Exchange Commission. Three of them rate the majority of bonds: Moody's, Standard & Poor's, and Fitch.

Credit-rating agencies issue ratings both for the bond issuer and for the bonds it issues. A rating for an issuer is roughly equivalent to an individual's credit score. According to the University of Wisconsin, a number of factors combine to compute this score, including financial metrics for the issuer, such as its debt-to-capital ratio; its previous credit history; its current and predicted revenues; and the reputation of its management.

Most rating agencies use a system that assigns letter grades for ratings, helping investors calculate the relative risk of their investments. For example, Standard & Poor’s reserves its highest rating, "AAA," for only a few firms. Bonds assigned a "BBB" are considered below investment-grade, and the very lowest rating, "D," is for bonds in default.

To compensate them for the risk they take in purchasing bonds that carry a low rating and, thus, a relatively high default risk, investors will demand that bond issuers offer them a higher interest rate. A low bond rating, therefore, generally means the bond will be more expensive for the issuer, which will have to pay out more money in interest.

Bond ratings are not absolute measurements of a bond's risk; they are estimates that can change over time. A bond often goes through many re-ratings throughout its lifespan in response to factors that the rating agencies believe will affect a borrower's ability to make good on the note. Even highly rated bonds can suffer a downgrade to junk status. Conversely, bonds with an initial low rating may earn an upgrade if their issuer's financial situation improves.