What Are Bond Rating Systems?
The U.S. Treasury, government agencies, states and municipalities and corporations all borrow money by issuing bonds. The terms of these loans are specified in documents called bond indentures and not all terms are the same. Bond rating agencies analyze the indentures and the underlying credits of the issuers and assign ratings.
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Types
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The two main bond rating agencies are Moody's and Standard & Poor's. Fitch also rates bonds but is primarily used for its insurance company credit ratings. Investment quality ratings are (Moody's/Standard & Poor's) Aaa/AAA, Aa/AA, A/A, and Baa/BBB. Ba/BB or below is considered speculative and unlikely to pay interest and principal.
Function
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In order to provide investors with a uniform and reasonably dependable way of knowing the quality of the bond, Moody's and Standard & Poor's each use a rating system. These systems are based on analysis and specific ways of reporting and categorizing the outcome of that analysis.
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Significance
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The bond rating system represents analysis that first looks at the credit quality of the issuing entity and then examines the indenture to rate the individual bond issues according to their likelihood of timely payment of interest and principal.
Considerations
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If the underlying credit is good but the individual bond indenture calls for suspension of interest payments under certain likely circumstances, then the bond will be rated below investment grade.
Warning
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Credits and ratings can change rapidly and not all the bonds issued by the same company are rated the same. Their payment provisions and whether they are first mortgage, debentures or subordinated debentures make a difference in the rating.
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