Bond Ratings and Rating Agencies

Posted: August 26th, 2021

Bond Ratings and Rating Agencies

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Bond Ratings and Rating Agencies

Bond Ratings

A bond refers toa commitment to the investor to complete a financial transaction, usually a debt by a government or a corporation (Cash, 2018; Donohoe, 2019). The debtor is required to make regular interest paymentsbefore returning the principal investment. Equally, the soundness of the initiatedcommitment is determined by the financial capabilities of the issuer(Cash, 2018). However, there are cases when bond issuers end up defaulting on their obligation, thus leading to loss of money on the side of investors (Donohoe, 2019). Therefore, it is always necessary to assess bond issuers’ capability to meet their obligations. It is referred to as bond rating. The rating ascertains the creditworthiness ofgovernment or corporate bonds(Corporate Finance Institute, 2020).Therefore, it implies bond ratings should provide ways of evaluating the risks that the bond issuer will be able to meet its debt obligations. 

Further, the investor has to critically study the bond issuer before making any investment of their money with them. Hence, this is achievable only by the use of bond ratings, which gives an evaluation of the bond issuer’s financial strength(Donohoe, 2019). The main benefit of classification is that it alerts an investor on the stability and quality of the bond and the issuer(Cash, 2018; Donohoe, 2019). The results of the ratings are always published by the credit rating agencies where bonds are rated on a scale that is assigned with ratings between AAA and D for some versions(Donohoe, 2019). A rating of AAA is described as extremely strong while D in a default(Cash, 2018). In this case, companies with bonds rated as AAA are financially secure since they can honor their financial obligations with the investors.For example, the U.S government holds an AAA rating because it is unlikely to default (Donohoe, 2019). Therefore, activities that make the bond issuer to be financially solvent increases its bond rating, whereasthat undermines the financial ability of a corporation or could result in a downgrade in rating.

Rating Agencies

On the other hand, rating agencies are there to help keep the process of evaluating bonds, objective, and independent. They act as the third party involved in determining the ratings for a bond(Cash, 2018). Hence, rating agencies include independent entities that assess the financial strengths of companies and governments, particularly concerning their ability to meet principal and interest payments on their debts (Corporate Finance Institute, 2020). In this case, the companies or corporations and governments are the bond issuers.As such, rating agencies develop proprietary processes that are used in the calculation of bond ratings. Some of the common considerations when developing a rating scale include all aspects concerning the current and predicted financial situation of the issuer or the industry.Other key elements include assessing the company’s cash flow, growth rate, and existing debt loads(Donohoe, 2019). Thus, companies that have big profits, substantial free cash flows with fewer debt obligations may attract higher ratings.

Once the financial strengths of companies and government entities are thoroughly assessed, the rating agencies assign letter grades to bonds, which indicates their credit quality(Cash, 2018). For example, the big three credit rating agencies include Moody’s investor services, Standard and Poor’s (S&P) located in the U.S, and Fitch that is located in the U.S and the U.K. They control the big part of the capital market. Equally, each of these agencies uses its unique letter-based score in indicating whether a debt has low or high default risks as well, relative financial stability of the issuer (Corporate Finance Institute, 2020; Cash, 2018). Thus, the notable roles played by rating agenciesin the financial sector include; risk assessment for particular debt security and borrower entity. Also, their importance is exhibited in structuring financial transactions like asset-backed securities, collateralized debt, and mortgage-backed securities, among others (Cash, 2018). Hence, their information is crucial to investors in aiding their understanding of creditworthiness and the development of financial markets.

References

Corporate Finances Institute. (2020). What are Bonding Ratings? Retrieved July 6, 2020, from https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/bond-ratings/

Cash, D. (2018). The role of credit rating agencies in responsible finance. Cham, Switzerland: Palgrave MacMillan.

Donohoe, A. (2019, March 13). Finance: How are Bond Ratings Determined [Review of how are Bond Ratings Determined, by J. Csiszar] Retrieved July 6, 2020, from https://finance.zacks.com/bond-ratings-determined-2859.html