Although bonds generally promise a fixed flow of
income, that income stream is not riskless unless the investor can be sure the
issuer will not default on obligation. While U.S. government bonds may be
treated as free of default risk, this is not true of corporate bonds. Therefore,
the actual payments on these bonds are uncertain, for they depend to some
degree on the ultimate financial status of the firm.
Bond default risk, usually called credit risk, is measured by Moody’s
Investor Service, Standard & Poor’s Corporation, and Fitch Investor
Service, all of which provide financial information on firms as well as quality
ratings of large corporate and municipal bond issues. International sovereign
bonds, which also entail default risk, especially in emerging markets, also are
commonly rated for default risk. Each rating firm assigns letter grades to the
bonds of corporations and municipalities to reflect their assessment of the
safety of the bond issue. The top rating is AAA or Aaa. Moody’s modifies each
rating class with a 1,2, or 3 suffix (e.g., Aaa1, Aaa2, Aaa3) to provide a
finer gradation of ratings. The other agencies use a + or – modification.
Those rated BBB or above (S&P, Fitch) or
Baa and above (Moody’s) are considered investment-grade
bonds, whereas lower-rated bonds are classified as speculative-grade or junk
bonds. Defaults on low-grade issues are not uncommon. For example, almost
half of the bonds that were rated CCC by Standard & Poor’s at issue have
defaulted within 10 years. Highly rated bonds rarely default, but even these
bonds are not free of credit risk. For example, in May 2001 WorldCom sold $11.8
billion of bonds with an investment-grade rating. Only a year later, the firm
filed for bankruptcy and its bondholders lost more than 80% of their
investment. Certain regulated institutional investors such as insurance
companies have not always been allowed to invest in speculative-grade bonds.
Bond Ratings
At times both Moody's and Standard & Poor's have used adjustments to these ratings: S&P uses plus and minus signs: A+ is the strongest A rating and A- the weakest. Moody's uses a 1,2, or 3 designations, with 1 indicating the strongest.
Moody’s S&P
Aaa AAA Debt rated Aaa and Aaa has the
highest rating. Capacity to pay interest and principal is extremely strong.
Aa AA Debt rated Aa and AA has a very strong capacity to pay interest and repay principal. Together with the highest rating, this group comprises the high-grade bond class.
A A Debt rated A has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in higher-rated categories.
Baa BBB Debt rated Baa and BBB is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher-rated categories. These bonds are medium-grade obligations.
Ba BB Debt rated in these categories is regarded, on balance, B B as predominantly speculative with respect to capacity to Caa CCC pay interest and repay principal in accordance with the Ca CC terms of the obligation. BB and Ba indicate the lowest degree of speculation, and CC and Ca the highest degree of speculation. Although such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. Some issues may be in default.
C C This rating is reserved for income bonds on which no interest is being paid.
D D Debt rated D is in default, and payment of interest and/or repayment of principal is in arrears.
Homepage: Moody's Investor Services
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