Bond ratings are representations of the creditworthiness of corporate or government bonds. Fixed Income Securities Fixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed, interest payments and repayments of the. . The ratings are published by credit rating agencies.
Non-investment grade bonds are riskier, but they offer a higher yield. Bond ratings prepared by professional analysts provide institutional and individual investors with a reliable source for making investment decisions.
The three private independent rating agencies – S&P, Moody’s, and Fitch – control almost 95% of the market share of the bond rating business.
Similar to S&P, the main purpose of Fitch’s rating is the assessment of a security’s default probability. It also uses a bond ratings scale similar to that of S&P. Extremely strong capacity to meet financial obligations.
Standard & Poor’s (S&P) is the oldest credit rating agency and one of the three Nationally Recognized Statistical Rating Organizations (NRSRO) accredited by the U.S. Securities and Exchange Commission. The company covers more than one million credit ratings on government and corporate bonds, structured finance entities, and securities.
Credit rating agencies play an important role in credit laws and regulations in the United States and a number of European countries. Moreover, rating agencies significantly affect global capital markets by providing an assessment of securities to investors. Credit ratings remain one of the essential sources of information regarding credit analysis and credit risk for investors.
The global financial crisis in 2007-2008 proved that the close relationship between credit rating agencies and large financial institutions could cause conflicts of interest. For example, credit rating agencies gave the highest ratings to many mortgage-backed securities.
Ratings are usually characterized by a letter grade, with the highest-rated bonds given a “AAA” (or similar) rating and the lowest-rated given a “C” or “D” rating . These ratings can have significant implications for issuers, bond investors and the capital markets. Most directly, ratings drive bond pricing: AAA bonds generally are the priciest (and hence have the lowest yields) while the progressively lower-rated bonds are less and less sought after (and have higher yields). And, if a rating company “downgrades” its rating on a bond due to some negative news released by the issuer or a market moving event, the bond will tend to lose value in the marketplace.
Rating companies have a profit incentive to be uncritical. Bond rating companies are being paid by the companies issuing the debt, so they have a big incentive to give favorable ratings so the company or underwriters will continue to come back.
Bonds are part of many investors' portfolios, held either as individual securities or through funds (such as mutual funds). A key consideration for bond investments is the rating given to a bond by a nationally recognized bond rating company. Investors consider these ratings in evaluating possible investments, but it is important to look beyond the mere rating when considering an investment in a specific bond or bond fund portfolio.
Following the 2008 financial crisis, companies that provide bond ratings were criticized for a rating process that failed to adequately assess the risk of certain investments as part of the rating process. As a result, some high-risk bonds were given inflated ratings to appear more creditworthy and appealing to investors. While corrective steps were taken following the financial crisis, there are concerns that inflated ratings continue. For this reason and others set out below investors should look beyond the rating when considering an investment in one or more bond or bond funds.
In the best situations, rating companies provide investors with an evaluation of the risks associated with debt securities. These securities include government bonds, corporate bonds, certificates of deposit (CDs), municipal bonds and others. The risk of investing in these securities is determined by the likelihood that the debt issuer — be it a corporation, or local government — will fail to make timely interest payments on the debt.
Over-reliance on ratings (Do your due diligence) - Many debt products are so complicated only the bond-rating companies have access to the details about the individual loans in the portfolios. As a result, investors fall into the trap of overly relying on the bond rating instead of doing their own due diligence.
Rating companies rely too much on the recent past. Bond rating companies often make the classic mistake of thinking recent financial history is likely to repeat, and only look at the last two years or fail to account for the greater systemic risks associated with certain products. Investors should use caution when considering bond offerings and not take a rating company's grade at face value without doing their own homework.