Bond credit ratings are the equivalent to an individual’s credit score and are designed to guage the risk that a bondholder will not receive a portion or all of the interest and principal payments they are due on a bond.
Different borrowers (bond issuers) are going to have different abilities to repay their debt.
The US government is considered to have a very low risk of not being able to re-pay debt, and therefor has a very good credit rating. To raise cash to re-pay debt, the US government has several tools at its disposal:
Corporations, for example the Ford Motor Company, have the following tools to re-pay debt:
With this in mind, it stands to reason that people are going to feel more comfortable, and therefore demand a lower interest rate, when investing in US Treasuries than they are when investing in the Ford Motor company. This is where bond credit ratings come into play.
If a corporation or government has multiple bond issues, they will often have different credit ratings. In the case of bankruptcy there there is an order in which bonds get re-paid. Those bond issues that get paid first will have a higher credit rating.
As there are literally millions of different types of bond issues out there, a standardized system is needed in order to know what the credit quality is of one bond vs. another. This is where the ratings agencies, or those companies that are tasked with classifying the credit worthiness via bond credit ratings come into play.
Bonds that have a high credit worthiness and a relatively low chance of defaulting on part or all of their debt.
These bonds are considered risky investments and tend to pay higher interest rates than Investment grade debt.
Lets move onto discussing the actual ratings issued by the Moody’s, S&P, and Fitch. Now I wish I could tell you that these fine institutions chose a simple and easy to understand rating system for telling a high quality bond from low quality bond, but unfortunately this is not the case. Not only are the bond credit ratings they put out complicated to understand, but they each have their own system.
This lesson is part of our Free Guide to the Basics of Investing in Bonds. Continue to the next lesson here.
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