Understanding Bond Ratings

August 20, 2011


There are over 80,000 issuers of municipal bonds in the United States. If you are thinking about buying municipal bonds, you should become familiar with credit ratings. As we stated in the previous chapter, credit risk should be your paramount concern. One data point to consider when evaluating the credit risk of a potential municipal bond is the bond’s rating.

There are 3 major rating agencies that evaluate thousands of issuers and their municipal bonds. The agencies are Standard and Poor’s (S&P), Moody’s, and Fitch. The ratings agencies assign ratings such as AAA and other ratings we’ll discuss below. The objective of the rating agency is to assign a municipal bond a credit rating to make it faster for market participants to evaluate risk. (Think of this in terms a person’s individual credit score – it makes loan decisions easier for lenders.) A credit rating performs the same service for institutional borrowers and investors. A bond’s credit rating is the rating agency’s opinion as to the creditworthiness of the bond’s issuer.

Ratings agencies take into account all of the economic characteristics of the issuer and the bond issue to assign a rating. They evaluate the economic well-being of the area: what is the Median income, how concentrated is community’s dependence on certain employers or industries, what is the diversity of the tax base, what is the rate of population growth, is the population younger or older, are tax revenues going up or down, why are revenues going up or down, what are the tax rates and can they be increased without decreasing revenues, is the economic area undergoing challenges, how affluent is the community, city, or state, etc? How safe are the revenues of the issuer if it is a revenue bond?

Each rating agency produces a ratings scale. You should understand what the ratings mean before you consider buying bonds. Generally speaking, the higher the bond’s rating, the lower the yield you are likely to receive. Just as an individual with a higher credit rating can borrow money from the bank at lower rates than a lower rated borrower, this same logic applies to bond issuers. The fundamental issue for any bond investor is to understand risk vs. yield. That is, how much more risk are you willing to assume to earn how much more? Bond ratings can help answer a part of the risk question.

Bonds are rated in the following way:

Moody’s Ratings

  • Aaa: This is pronounced “triple-A”. This is the highest rating Moody’s assigns issuers and individual bond issues. This is the strongest category of creditworthiness.
  • Aa: Pronounced “double-A”. This the next highest tier of Moody’s. It implies very strong creditworthiness.
  • A: Pronounced “single-A”. This is the third highest tier. It implies above average creditworthiness.
  • Baa: Pronounced “B double-A”. This is the fourth highest tier and the lowest tier of what is generally considered ‘investment grade’. This implies average creditworthiness.

If you are new to bond investing, you should not buy any bonds below an A rating. Even if you are knowledgeable, it’s unnecessary for you to take on risk in your bond portfolio. Leave the risk and speculation for your stock portfolio or for investments in your cousin’s foolproof business idea.

The other Moody’s Ratings are as follows:

  • Ba: Pronounced “B-A”. This implies below-average creditworthiness.
  • B: Weak creditworthiness
  • Caa: Very weak creditworthiness
  • Ca: Extremely weak creditworthiness
  • C: Weakest creditworthiness

Moody’s also adds a numerical number from 1 to 3 within each rating category for everything other than Aaa-rated bonds (triple-A). For instance, ratings in the double-A category will look like this: Aa1, Aa2, Aa3. 1 is better than 3. To avoid confusion, the letters are by far more important to pay attention to. The number differentiates bonds with a rating category.

Standard and Poor’s Ratings

  • AAA: “triple-A.” Highest rating. Extremely strong creditworthiness.
  • AA: “Double A.” Very strong creditworthiness.
  • A: “Single-A.” Strong creditworthiness.
  • BBB: “Triple-B.” Adequate creditworthiness. Considered the lowest of what is known as an investment-grade bond rating.

Again, you should avoid buying anything below single-A. Definitely avoid anything with the following ratings; they are regarded as speculative by S&P:

  • BB: “Double-B”
  • B: “Single-B”
  • CCC: “Triple-C”
  • CC: “Double-C”
  • C: “Single-C”

S&P adds a plus “+” or minus “-” at the end of its ratings to differentiate bonds within a category. For instance, for bonds rated “double-A”, AA+ is better than AA-.

Fitch’s Ratings

Fitch has multiple rating systems depending on the type of debt, but its most popular are the National Long-Term Credit Ratings and they are as follows:

  • AAA: Denotes the highest rating. This rating is given to those with the lowest default risk relative to all other issuers or obligations in the same country.
  • AA: Denotes expectations of very low default risk relative to other issuers or obligations in the same country.
  • A: Denotes expectations of low default risk relative to other issuers or obligations in the same country.
  • BBB: Denotes a moderate default risk relative to other issuers or obligations in the same country.
  • BB: Denotes an elevated default risk relative to other issuers or obligations in the same country.
  • B: Denotes a significantly elevated default risk relative to other issuers or obligations in the same country.
  • CCC: Denotes that default is a real possibility.
  • CC: Denotes that default of some kind appears probable.
  • C: Denotes that default is imminent.

Upgrade and Downgrades. On an ongoing basis, Moody’s and S&P upgrade or downgrade bond issuers and bond issues. For instance, if a state’s fiscal picture is deteriorating, Moody’s may downgrade a state’s rating. For example, it could go down from Aaa down to Aa.

When a bond issuer gets downgraded, the yield on the bonds from that issuer will usually go up; this is to compensate prospective buyers of the bonds for a perceived increase in risk reflective of the lowered rating. For existing bondholders, the price of the bonds they hold will go down. A change in rating could mean little to an existing bondholder provided that 1) the bondholder does not plan on selling the bonds prior to maturity, and 2) the bonds do not default.

In 2011, S&P downgraded U.S. debts from AAA to AA, the first-ever downgrade since it gave the U.S. the top grade back in 1941. The move came as very controversial, as the Obama administration accused the credit rating agency of grossly overstating national debt. Moody’s stuck with its Aaa for the U.S., creating even more of a stir as the two top agencies disagreed on the classification of the country’s debts.

In the next couple of chapters, we will review the default characteristics of various types of issuers, history of municipal bond defaults, and recovery rates.

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