As we were discussing about government bond, it is one of the safest available investment. For corporate bonds however, how do we trust them? How can we know how good / bad they are? Therein comes bond ratings, given by accredited agencies.
Like report card tracking an individual’s performance, rating agencies evaluates bond issuers. They assess their creditworthiness. In addition, they consider bond issuer’s financial strength, ability to pay in a timely fashion and financial stability of issuers. They provide investors with quantitative and qualitative descriptions of the available securities
Bond Rating process
Bonds rating process extends beyond ratios and balance sheet reviews. Operational conditions plays a big role in determining the credit. For a corporation, ratings are based on current business like margins and earnings growth, while government issuers are rated in part based on the strength of their economies.
Rating used by agencies
Generally, bonds ratings are between some version of AAA and D. AAA-rated bonds represent the most secure. Higher the bond rating, the more favorable the terms will be for the issuer. High-rated bonds have lower interest rates. Investors need less compensation for the risk of default. Results in lower borrowing costs for issuers. However, a credit rating is not a recommendation to purchase a particular bond. It is merely a review of their current situation.
For better understanding, let’s consider Moody’s credit rating:
According to Moody’s, the purpose of its ratings is to “provide investors with a simple system of gradation by which future relative creditworthiness of securities may be gauged”.
Moody’s uses a standardised rating scale from AAA to C. AAA is highest and C is lowest. You can find what each Moody’s rating here.
Similarly CRISIL is another rating agency providing ratings, research, risk and policy advisory services. They too maintain a clear rating system. For instance you can check out their rating systems here.
In conclusion, use ratings as a navigation system. As you know, bonds tend to have a long tenor. They will be subjected to fluctuating interest rates, inflation risks, geopolitical turmoil etc. Carefully weigh the risks of investing in these bonds. Therefore, keep a periodic tab once you are invested in.