Bond credit rating explained
Important information: this section of our website aims to help you understand and use this important asset class, it is not personal advice. Neither income or capital is guaranteed, the value of investments can fall as well as rise and you could get back less than you invest. Tax rules can change and the benefits depend on your personal circumstances. Bonds may not be suitable for all investors, if you are unsure of their suitability for your circumstances please ask for financial advice.
Credit quality is a measure of the issuer's ability to service and repay its debt. Investors may have their own knowledge and views on a company's ability to repay debt or, alternatively, they can view the credit rating assigned to issuers by several of the credit rating agencies. Credit agencies deploy considerable resources to assess both the issuer and the individual bond. It is in the interest of bond issuers to obtain these ratings. That said, it is the company itself which pays the ratings agency to rate their bonds and that does create a potential conflict of interest. There are two main international credit ratings agencies, namely Moody's and Standard & Poor's.
Credit ratings are used by most banks and fund managers when establishing the suitability of a bond as an investment but, remember, situations change quickly, and so can credit ratings. You can look up the rating of most bond issuers on the Moodys and Standard & Poors websites. Much research on this subject is also conducted by broking houses and investment banks, as well as some good up and coming independent analysts. However it is worth bearing in mind that movements in the issuer's share and bond prices will usually occur prior to any change in the credit rating.
Here is Standard & Poor's definition of the ratings it awards to organisations issuing bonds:
| Credit rating | Definition |
|---|---|
| AAA | Extremely strong capacity to meet its financial commitments. AAA is the highest issuer credit rating. |
| AA | Very strong capacity to meet its financial commitments. It differs from the highest
rated
obligors The obligor is a person or entity, legally required to provide a benefit or payment to another. |
| A | Strong capacity to meet its financial commitments, but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories. |
| BBB | Adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. |
| Below BBB | Bonds rated below BBB are known as 'non-investment grade', 'high yield' or, less charitably, as 'junk' bonds. These bonds are of a more speculative nature, and imply a certain degree of risk. In view of this, the incremental yield available on the instrument must be adequate to compensate the investor for this risk. Standard & Poor's gives the following definitions for non-investment grade debt. |
| BB | Less vulnerable in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligor's inadequate capacity to meet its financial commitments. |
| B | More vulnerable than the obligors rated BB, but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments. |
| CCC | Currently vulnerable, and is dependent upon favourable business, financial, and economic conditions to meet its financial commitments. |
| CC | Currently highly vulnerable. |
| C | May be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. C ratings will also be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying. |
Plus (+) or minus (-) The ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.
Ratings AAA through to BBB are known as 'investment-grade debt'. As a rule of thumb, investors managing portfolios where the risk should be relatively low, and security of income and capital is more important, will restrict themselves to bonds rated AAA and AA, with perhaps a few single A investments. Consider also a bond's credit history. Has the rating improved or declined over time? Bonds subject to a potential re-rating will be on 'credit watch'.
Types of issuer
The different classes of issuer that are on the Sterling bonds markets:
- Government bonds (gilts): the risk of default for these can range greatly depending on the government issuing. As a rule of thumb, the bonds with the least risk of default are the high-quality sovereign issuers such as the UK and the larger and wealthier European countries. Risk of default should not be confused with market risk, or price volatility. A bond can be 100% guaranteed by all the governments in the world and still experience price swings between issue and redemption, typically driven by changing interest rate volatility.
- Supranational bonds: these are issued by agencies such as the World Bank and the European Investment Bank which are supported by their sovereign members.
- Corporate bonds: these are bonds issued by corporations, typically large quoted companies. The life of a company is full of ups and downs and it is fair to say that in most cases corporate bonds carry a greater risk than those issued by major governments or banks. Factors affecting a company's credit rating include cash flow, profitability, asset valuations and unforeseen events such as legal action, a takeover or a change of the trading environment. The yield on these bonds will normally be greater than that available on bank debt.
- Other types of issuers: there are numerous bonds issued to fund mortgage loans, credit card loans and other more complex financial transactions. These types of bonds, often known as mortgage-backed securities (MBS) and asset-backed securities (ABS) are not generally available to the investing public in the UK. The credit quality of these can vary and investors should be sure of their suitability before buying.