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Specific factors that the agencies look at include:
- The strength of the issuer’s balance sheet. For a corporation, this would include the strength of its cash position and its total debt, countries are assessed on the total level of debt, their debt- to-GDP ratio. and the size and directional movement of their budget deficits.
- The issuer's ability to service its debt via the cash left over after expenses are subtracted from revenue.
- For a corporation, ratings are based on current business conditions, including profit margins, earnings growth, etc. while government issuers are rated in part based on the strength of their economies.
- The future outlook for the issuer, including the potential impact of changes to its regulatory environment, industry, ability to withstand economic adversity, tax burden, etc. or in the case of a country, its growth outlook and political environment.
Standard & Poor’s ranks bonds by placing them in 22 categories, from AAA to D. Fitch largely matches these bond credit ratings, whereas Moody’s employs a different naming convention. In general, the lower the rating, the higher the yield since investors need to be paid for the added risk.
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Also, the more highly rated a bond the less likely it is to default, as outlined here and here .
Keep in mind, however, that a high rating doesn’t remove other risks from the equation, particularly interest rate risk. As a result, it can provide information about the issuer but can’t necessarily be used to predict how a bond will perform. However, bonds tend to rise in price when their credit ratings are upgraded. and fall in price when the rating is downgraded.
How much do ratings really mean? While they provide a general guide, they shouldn't be relied upon too closely. Consider this quote from Peritus Asset Management's whitepaper, The New Case for High Yield. published in April 2012:
"Investors should understand what the ratings agencies themselves say about their ratings. Among their various disclosures, the ratings agencies caution that their ratings are opinions and are not to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security. So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 25+ years. We see the ratings agencies as reactive not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions."
With that warning in mind, here’s an explanation of the bond credit rating categories used by S&P, with the equivalent Moody’s ratings parentheses:
AAA (Aaa) — This is the highest rating, signaling an “extremely strong capacity to meet financial commitments,” in the words of S&P. The U.S. government is given
this top rating by Fitch and Moody’s, while S&P rates its debt at notch lower. Four U.S. corporations – Microsoft, Exxon Mobil, Automated Data Processing, and Johnson & Johnson – are rated AAA, while S&P ranked 14 of 59 countries AAA as of February, 2013.
AA+, AA, AA- (Aa1, Aa2, Aa3) — This rating category indicates that the issuer has a “very strong capacity to meet its financial commitments.” The differences from AAA are very small, and it’s very rare that bonds in these credit tiers will default. From 1981 through 2010, only 1.3% of global corporate bonds originally rated AA eventually went into default. (Keep in mind, bonds usually experience ratings downgrades prior to actual default).
A+, A, A- (A1, A2, A3) — S&P says about this category: “Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.” In other words, while Microsoft or an AAA-rated government issuer could withstand a prolonged recession without losing the ability to make its debt payments, this is somewhat more in question when it comes to securities in the “A” category.
BBB+, BBB, BBB- (Baa1, Baa2, Baa3) — These bonds have “adequate capacity to meet financial commitments, but more subject to adverse economic conditions or changing circumstances” – in other words, a step down from the A rating tier. BBB- is the last tier at which a bond is still considered “investment grade.” Bonds rate below this level are considered “below investment grade” or, more commonly, “high yield ” – a more risky segment of the market.
BB+, BB, BB- (Ba1, Ba2, Ba3) — This is the highest rating tier within the high yield category, but a BB rating indicates a higher level of concern that deteriorating economic conditions and/or company-specific developments could hinder the issuer’s ability to meet its obligations.
B+, B, B- (B1, B2, B3) — B-rated bonds can meet their current financial commitments, but their future outlook is more vulnerable to adverse developments. This helps illustrate that credit ratings take into account not just current conditions, but also the future outlook.
CCC+, CCC, CCC- (Caa1, Caa2, Caa3) — Bonds in this tier are vulnerable right now and, in S&P’s words, are “dependent on favorable business, financial and economic conditions to meet financial commitments”. Fitch uses a single CCC rating, without breaking it out into the plus and minus distinctions as S&P does.
CC (Ca) — Like bonds rated CCC, bonds in this tier are also vulnerable right now but face an even higher level of uncertainty.
C — C-rated bonds are considered most vulnerable to default. Often, this category is reserved for bonds in special situations, such as those where the issuer is in bankruptcy but payments are continuing at present.
D (C) — The worst rating, assigned to bonds that are already in default.
The data below shows what percentage of global corporate bonds fell into each category, as calculated by S&P, on January 1, 2010: