Lesson 20: Bond Credit Ratings

Bond Credit Ratings

November 26th, 2011 by

credit ratings agenciesA bond is a debt that the issuer promises to pay the bondholder. To understand the certainty of repayment, it is important to understand the financial health of the issuer.   For example, U.S. Treasury bonds are backed by the U.S. Government’s ability to collect taxes, which is immense; bonds issued by private corporations do not have such a guarantee.

Rating Agencies

Rating agencies such as Moody’s and Fitch Ratings look at a variety of factors to evaluate and try and place a specific grade on the on the likelihood that a particular bond (or other debt obligation) will be re-paid. It should be noted that not all the debt from a particular corporation or government entity will be rated the same.  The best rating is AAA, which indicates almost no danger of default.  Ratings then go down through AA+ (Aa1), then through the B’s and finally the C’s (D’s indicate an organization in default). To be “investment-grade”, debt must be BBB- (Baa3) grade or better.

Two agencies may not however use the same criteria or rate corporations and/or their bond offerings in the same way. With this in mind debt ratings are useful supplementary data, but its still important to do your own research as well. Here are some things to think about when evaluating individual bond issues:

Debt compared to company worth

The higher the worth of a company compared to its debt, the more likely it will be able to pay bondholders.  The worth of a company can be assessed in different ways:

Market capitalization

Market capitalization is the number of shares a company has outstanding times the price of those shares. Put simply, its the value of the company. A large market capitalization (for example over $1 billion) reflects the market’s opinion that the company is not in financial trouble, and leaves open further possibilities of raising funds on the market (and continuing to pay interest on bonds)

Assets

If the worst happens and a company goes bankrupt, you may be more likely to be paid as a bondholder if its assets are in gold ingots rather than rubber duckies.

Debt compared to company income

One company may only take on debt that is manageable at their existing level of revenues. Another company may borrow based on plans for expansion and future expectations of earnings. If each company offers a bond with the same maturity and yield, then all else being equal the bond offered by the first company is probably the safer proposition.

Debt seniority

When a debt issued by a corporation is more “senior”, its repayment takes priority over less senior (or “subordinate”) debt. The first people to lend money to a company (for example, the bank) usually hold the most senior debt. Corporate bondholders (you for example as an investor in bonds) may be next in line. Shareholders have then a lower priority: whereas bond interest payments are a contractual obligation, shareholder dividend payments are discretionary.

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