There is a rating system for bonds that, although many people have heard of AA and AAA-rated bonds, even many investor do not understand what those ratings actually mean–especially when the ratings drop below the two higher classifications. Moody’s, Standard and Poor’s, and Fitch all have basically similar rating systems.
The two most widely-known are Moody’s and S & P. Accordingly, I have listed the ratings for each company; however, the basic system is the same for Fitch, as well as other, lesser-known rating companies.
Moody’s S & P
The ratings descend through the first four letters of the alphabet. Both Moody’s and
S & P identify stronger and weaker credits, within each of the primary twelve ratings, by adding a suffix (1 and 3 for Moody’s and + and – for S & P).
The first four ratings are considered to be “Investment Grade”. Debt that carries ratings below Baa and BBB are considered to be “Junk or High Yield” Bonds. As the ratings descend through the twelve basic categories, the underlying debt gradually drops in quality. Lower-rated bonds are assumed to have more risk and generally the issuer would pay a higher interest rate to sell its bonds.
Bonds issued by the US Treasury, Agencies and Municipal (State and Local) bonds
are rated on what the various credit rating-agencies believe is their ability to repay Principal and Interest. For Governments, the rating agencies consider such things as the Tax Base, Population, Average Income of the Residents, Current Budget, Total Debt Outstanding as a percentage of the Tax Base. GDP (Gross Domestic Product or the Total of All Goods and Services produced by an Economy) is a key statistic for US Treasury securities.
For corporations, the ability of the issuer to repay Principal and Interest is still the main consideration; however, analysts focus on: the Company’s Balance Sheet; the Income Statement; Percentage of Long-Term Debt to the Total Capital, etc.) I believe that the amount of Shareholder Equity, as a percentage of Total Capital, is a key factor since the Common Stock serves as a buffer for Bondholders in the event of Bankruptcy.
AS ALWAYS, CONSULT YOUR FINANCIAL ADVISOR REGARDING WHETHER BONDS SHOULD BE INCLUDED IN YOUR PORTFOLIO, HOW MUCH, THE SPECIFIC TYPE AND TO RECOMMEND PARTICULAR SECURITIES.