Determining the Rating of Corporate Bonds

There are several agencies whose primary purpose is determining the ratings of corporate bonds. While each uses slightly different factors and follows slightly different conventions, they have certain similarities that are critical. If you understand the basic process of how the rating agencies approach the process, you will be better equipped to make decisions about how to invest.

The Agencies

There are three primary rating agencies that are charged with the task of assigning ratings to corporate bonds: Standard & Poor’s, Moody’s, and Fitch. Each of these agencies evaluates corporate bonds and assigns an appropriate level based on their respective naming conventions. While there are differences, in general AAA is the highest rating, dropping to AA to A and so on. In some cases, pluses and minuses are used as well.

Rating Criteria and the Yield Curve

To perform their analysis, the agencies consider a variety of factors. The common goal is to assign a rating that signals to investors what quality the particular bond carries. This allows investors to make apples-to-apples comparisons of similar fixed-income instruments.

When considering treasury bonds, the yield curve graphically depicts the yield for every maturity date available. Using this as a baseline, you can draw a yield curve for every rating level of corporate bond. These curves all depict a spread to treasuries that represent the premium that investors demand for moving to the higher risk of corporate debt over government debt.

How Ratings Are Determined

When arriving at a rating, the agencies are primarily concerned with default risk. Their goal is to give you an idea of how certain you can be of receiving interest payments for the life of the bond. This is similar to a credit rating for an individual and is used in a similar way-–it helps you decide what kind of credit risk the company represents and whether you are willing to lend it money. Because bonds have different maturities, the general financial health of the company must be considered. This is because the agency must be concerned with not only the company’s ability to make interest payments today but where the company will be years into the future. If there are concerns as to how sustainable the company will be into the future, the bonds will receive a lower rating.

Some of the other factors that the rating agency will consider include how the bond is structured (where it falls in seniority in case the company runs into problems), the interest payment history of the company, the overall debt level of the company, the industry, the general health of the company, the operating history of the company, the revenues of the company and the strength and quality of the company’s management team. Each of these factors contributes to the overall opinion of what level of risk the company represents. If you were to make each of these judgments independently, it would be difficult to compile sufficient data. By boiling these factors down into a simple rating, the various agencies aid you in making sound investment decisions.

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