An Educational Look at Bond Credit Ratings
Credit ratings are the most common benchmark used to assess the ability of a bond issuer to make timely payments of interest and principal. As credit ratings are subject to change without notice it is important to review a bond's credit rating, and the effect a rating change could have on the bond, before you invest. In measuring credit quality, U.S. Treasury securities, which are backed by the ‘full faith and credit’ of the U.S. Government, are accepted within the investment community as the benchmark, against which the credit quality of all other fixed income securities are measured. Here, we take an informative look at the bond credit rating system.
An Overview of the Rating Agencies
When considering a potential investment, investors should carefully compare the credit qualities of available bond issues before they invest. Credit quality can be implied, as in the case of U.S. Treasuries, or it may be specified through a rating assigned by a ratings agency. The SEC defines a Nationally Recognized Statistical Rating Organization (NRSRO) as an entity that meets guidelines deemed necessary to offer ratings upon issuers. Here we consider the ratings assigned by three NRSRO’s:
- Moody’s Investors Service (“Moody’s”)
- Standard & Poor’s Corporation (‘S&P’)
- Fitch Ratings (’Fitch’)
In determining the creditworthiness of an issuer, Moody's, S&P and Fitch focus on the issuer’s overall financial condition, as well as that of the industry or sector in which the issuer operates. A rating represents the opinions of the rating agency at a particular point in time. Ratings on individual issues are continuously revised to reflect any industry, sector, company or municipal developments, and these ratings changes can have a distinct effect on a bond’s market price. The rating agencies classify bond issues as either ‘investment grade’ or ‘below investment grade.’
Investment Grade Bonds
These bonds are generally more appropriate for conservative clients. They typically provide the highest degree of principal and interest payment protection, and are generally the least likely to default.
Below Investment Grade Bonds
Securities rated below investment grade are often referred to as ‘high yield’ or ‘junk’ bonds and may be suitable only for aggressive investors willing to accept greater degrees of credit risk. Below investment grade bonds are considered speculative investments, involve a greater risk of default and tend to be more volatile than investment grade bonds. The yields on these bonds are generally higher to compensate for the additional risk.
Other Rating Categories
"Watchlist," "CreditWatch" and “Rating Watch”
The agencies monitor rated securities and issuers. When they determine that a rating change may be warranted, the debt issue is placed on the "Watchlist" (if reviewed by Moody's), "CreditWatch" (if reviewed by S&P), or “Rating Watch” (if reviewed by Fitch).
These lists are considered a leading indicator of adjustments in credit quality, and include the names of issuers which the agencies believe have a likelihood of changing. These changes are usually due to developing events or trends, which may warrant a more extensive examination of the issuer’s outstanding debt and financial condition.
Bond obligations are assigned directions:
These lists indicate the names of debt issues that the rating agencies believe have a likelihood of a ratings change. They do not indicate that an actual rating change will take place. In certain cases, names may be removed from the lists without a changing in rating. Please note, a rating change may also occur without first appearing on the list.
Fixed Income Investment Considerations
In addition to credit risk, fixed income investments are exposed to three other main risks:
- Interest Rate Risk:
- The risk that the market value of securities in your portfolio might rise or fall due to changes in prevailing interest rates. All else being equal, if interest rates fall, bond prices will rise and vice versa.
- Reinvestment Risk:
- The risk that the income stream from a given investment may be reinvested at a lower interest rate.
- Liquidity Risk:
- Morgan Stanley provides access to the secondary market if you wish to sell your bonds prior to maturity. However, the level of liquidity can vary between bond issues and the price you receive may be more or less than the par value or your original purchase price. Lower rated securities are generally less liquid than investment grade securities.
The Correlation Between Credit Ratings and Risk of Default
An inverse correlation exists between the credit quality and the default probability of a given bond: the higher the credit rating, the lower the probability of default. While the higher yields and the potential for capital appreciation of lower-rated bonds may seem attractive, they should be carefully considered (within the parameters of your portfolio) in relation to the greater chance of a ratings downgrade and/or default occurring.
