When Corporates and States issue bonds, they typically receive a credit rating on the debt’s creditworthiness from a Rating Agency. The rating given incorporates various factors such as the strength of the issuer’s finances and its prospects.
Rating allows investors to understand how likely a bond will default or fail to make its interest and principal payments on time. Generally, the lower the rating, the higher the yield. This is because investors need to be compensated for the added risk. Additionally, the more highly rated a bond, the less likely it is to default.
Bond rating can reflect some forward-looking information, but they are largely based on historical financial information. As a result, they do not offer a definitive indication of an entity’s future performance.
Rating Agencies look at specific factors that focus on an entity’s capacity to meet its financial commitment by looking at:
- The strength of the issuer’s balance sheet
- The issuer’s ability to make its debt payments
- The condition of the issuer’s operations
- The future economic outlook for the issuer
- Current business conditions including profit margins and earnings growth (Corporate)
- The strength of their economies (State)
A bond issuer’s financial model is essential when ratings are determined. The balance sheet (the financial statement that displays assets, liabilities and equity) is used in conjunction with the statement of cash flow to determine how a company uses the debt and cash it has.
Each business is rated on the likelihood that they will pay off their liabilities after paying their expenses and how they finance their operations. For States, the rating methodology will include their total level of debt, debt-to-GDP ratio and the size and directional movement of their budget deficits.
Each Rating Agency evaluates the potential impact of changes to a government’s regulatory environment and its ability to withstand economic adversity. They also weigh consumer tax burdens, growth outlook and the political environment.
DataPro, the technology-driven Credit Rating Agency, ranks bonds by placing them in eight (8) categories from AAA to DD. Each of the ratings mean something different regarding a bond issuer’s capacity to pay off its debts or make a full interest repayment if they have fallen behind.
Bonds with ratings between AAA (Triple A) and BBB- (Triple B minus) are referred to as Investment-Grade bonds. They are typically viewed as less risky because bond issuers are more likely to pay off their debts.
Bonds rated at and below BB by DataPro are considered below Investment-Grade or “junk” bonds. These bonds have a higher risk because the issues carry more debt than Investment-Grade bonds whose issues have higher debt payoff capacity.
Adapted from “The scoop on Bond Credit Rating” by Thomas Kenny.