How Are Bond Ratings Determined?

The credit quality of a bond is indicated by the grade or rating that’s assigned to the bond by a rating service. The rating reflects the service’s evaluation of the bond issuer’s financial strength. Consequently, the rating is an indication of the issuer’s practical ability to pay a bond’s buyer the instrument’s principal amount and interest in a timely and agreed-upon manner.

Two credit agencies – Standard and Poor’s and Moody’s Investors Service – dominate the credit rating industry by holding about 80 percent of the industry’s market share, writes Satyajit Das in "Extreme Money: The Masters of the Universe and the Cult of Risk." Those two firms, along with every other credit agency, are registered with the Securities and Exchange Commission as a statistical rating organization. Each assigns a statistically determined rating to debt securities, including corporate and government bonds. Each credit rating is represented by a letter designation.

Bond ratings are stated using letters of the alphabet and other designations, such as a plus or minus sign. Each rating assigned by a credit rating agency signifies the rating agency's opinion regarding the bond issuer’s relative ability to repay the bond’s principal and interest. In the case of an S&P rating, a plus or minus sign raises or lowers a bond’s rating, and therefore its relative position in a group.

Each rating agency has a unique bond rating framework or tiers. For example, the “AAA” Standard and Poor’s rating is assigned to a bond of the highest credit quality, issued by a company or government that’s more than able to pay its bonds’ principal and interest when due. In turn, the “C” S&P rating is given to a bond issued by a company that, according to S&P, is unlikely to repay the bonds’ principal and interest as agreed. A bond is of investment grade if it has a Standard and Poor’s credit rating of BBB- or higher.

U. S. government bonds are safer in terms of the likely return of an investor’s principal and the payment of interest than other bonds issued, followed by those issued by U. S. Agencies, corporations and local governments. Consequently, while the U. S. government bond rating will be “AAA," the rating for a bond issued by a local government might be ”C-.”

Each of the following Standard and Poor’s bond ratings, from “AAA” to “D,” represents the likelihood a bond issuer will pay either a bond’s principal or interest in a timely manner as promised.

• AAA:  The bond issuer's capacity to meet its financial commitment on the obligation is extremely strong.
• AA: The bond issuer's capacity to meet its financial commitment on the obligation is very strong, but slightly less than "AAA."
• A: The bond issuer's capacity to meet its financial commitment on the obligation is strong, but slightly more susceptible to the adverse effects of changes in circumstances and economic conditions than higher-rated obligations.
• BBB: Adverse economic conditions or changing circumstances are more likely to weaken the ability of  the bond issuer to meet its financial commitment on the obligation.
• BB: The obligation likely has some quality and protective characteristics, but these characteristics may be outweighed by the bond issuer's exposure to large uncertainties or adverse conditions.
• B:  The bond issuer's ability to meet its financial commitment on the obligation will likely be affected by adverse business, financial and economic conditions.
  
• CCC: The bond issuer is not likely to be able to meet its financial commitment on the obligation should adverse financial, business or economic events occur.
  
• CC: The bond issuer is likely to default on the obligation.
  
• C: The obligation is highly vulnerable to nonpayment and the debt is expected to have lower ultimate recovery that other higher-rated obligations.
  
• D: The obligation is in default for non-payment of principal or interest.

For governments and corporations alike, a credit rating issued by a credit rating agency reflects the agency’s opinion regarding the likelihood the bond issuer will repay its debt. For this reason, the credit rating influences the interest rate the bond issuer must pay on its debt. The more likely the debt will be repaid, the less the chance of default and the less influence the probability of default has on the debt’s interest rate.