Bond Ratings

Independent credit rating agencies are called on to evaluate the credit worthiness of financial obligations issued by governments or businesses and to issue a credit rating based on their findings. A credit rating is a rating agency’s opinion on the general creditworthiness of a debt issuer or the creditworthiness of an issuer with respect to a particular debt security or other financial obligation.

During the credit rating process, the rating agency analyzes the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. Upon completion of its analysis, the rating agency assigns a credit rating based on the issuer’s likelihood of default. A lower rating is indicative of a bond that has a greater risk of default than a bond with a higher rating.

In general, credit rating agencies use a letter assigned rating system. The letter indicates the level of risk for a given investment, which affects the interest rate investors are willing to accept in return. For example, a highly-rated security (e.g., a AAA rated municipal bond backed by a stable government agency) has a low interest rate because it is a low-risk investment. Conversely, a lower-rated security generally carries a higher interest rate in order to attract buyers to this high-risk investment. In this case, a higher interest rate is being provided in exchange for the investor taking on the risk associated with a higher likelihood of default.

In the United States, there are three companies that dominate the credit rating industry: Fitch Ratings, Moody’s Investors Service, and Standard and Poor’s. Each rating agency has developed its own system of rating sovereign and corporate borrowers. Comparative tables displaying the rating conventions for long-term and short-term obligations are shown below.

Long-term ratings generally include financial obligations with original maturities greater than one year. Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds rated lower than BBB/Baa are considered high yield, or speculative.

Fitch

Moody’s

S&P

Long-Term Credit Quality

AAA

Aaa

AAA

Highest credit quality

AA+

Aa1

AA+

Very high credit quality

AA

Aa2

AA

AA-

Aa3

AA-

A+

A1

A+

High credit quality

A

A2

A

A-

A3

A-

BBB+

Baa1

BBB+

Good credit quality

BBB

Baa2

BBB

BBB-

Baa3

BBB-

BB+

Ba1

BB+

Speculative

BB

Ba2

BB

BB-

Ba3

BB-

B+

B1

B+

Highly speculative

B

B2

B

B-

B3

B-

CCC

Caa1

CCC+

Substantial credit risk

Caa2

CCC

Caa3

CC

Ca

CC

Very high levels of credit risk

C

C

Exceptionally high levels of credit risk

D

C

D

Default
Short-term ratings are generally assigned to those obligations with an original maturity of no more than 365 days.

U.S. Municipal Short-Term Debt Ratings

Fitch

Moody’s

S&P

Short-Term Credit Quality

F1+

MIG 1

SP-1+

Highest credit quality

F1

MIG 2

SP-1

High credit quality

F2

MIG 3

Good credit quality

F3

MIG 4

SP-2

Fair credit quality

B

SG

SP-3

Speculative credit quality

C

High short-term default risk

D

Default


SHORT-TERM DEBT RATINGS

Fitch

Moody’s

S&P

Short-Term Credit Quality

F1+

P-1

A-1+

Highest credit quality

F1

A-1

High credit quality

F2

P-2

A-2

Good credit quality

F3

P-3

A-3

Fair credit quality

B

NP             (Not Prime)

B

Speculative credit quality

B-1

B-2

B-3

C

C

High short-term default risk

D

D

Default

Rating agencies continuously monitor issuers and may change their ratings based on changing credit factors. Rating agencies will generally signal that they are considering a rating change by placing the entity or financial obligation on Rating Watch (Fitch Ratings), Under Review (Moody’s), or CreditWatch (S&P).

Investment-Grade vs. Speculative-Grade

Investment-Grade Bonds

Investment-grade companies are perceived to be of higher credit quality and lower risk of default compared to lower rated, speculative-grade, companies. A bond is considered investment grade if its credit rating is BBB- or higher by Fitch Ratings or Standard & Poor’s, or Baa3 or higher by Moody’s.

Speculative-Grade Bonds

Speculative-grade (also known as “high-yield” or “junk”) bonds are typically issued by companies with troubling fundamentals, companies that are in a particularly competitive or volatile sector, or newer companies. And while a speculative-grade credit rating indicates a higher probability of default, this higher risk is often offset by higher yields. In some instances, bonds may receive an investment-grade credit rating, but are later downgraded to speculative-grade if the issuer’s fundamentals deteriorate, and vise versa.

Rating Inconsistencies

Based on historical default rates, municipalities have exhibited significantly lower default rates than corporate borrowers of the same credit rating. For example, an “A” rated corporate bond would carry more risk than an “A” rated municipal bonds. In acknowledgement that municipalities were being held to a different standard from corporate and sovereign debt, Fitch and Moody’s began a recalibration of their municipal ratings in 2010, attempting to bring municipal ratings in alignment with other sectors.

Bond Insurance

The credit quality of a bond can be enhanced by bond insurance, which is provided by an insurance firm that guarantees the timely payment of principal and interest on bonds in exchange for a fee. Insured bonds receive the same rating as a corporate rating of the insurer, which is based on the insurer’s capital and claims-paying resources.