What is a Bond Rating?

Definition: A bond rating is a graded evaluation of an bond issuer’s default risk designated by a letter grade of AAA through D illustrating the bond’s overall credit quality. In other words, it is a score that is assigned to a bond as an indication of its reliability and potential fulfillment of terms, conditions and payments.

What Does Bond Rating Mean?

Rating agencies are in charge of evaluating and assessing a bond’s rating. These entities evaluate a bond issuer’s financial strength and its ability to pay a bond’s principal and interest by thoroughly reviewing its financial statements and business conditions. Bond ratings are very important for investors because they inform them about the stability and quality of the bond; thus, ratings affect a bond’s price, its yield, and its appeal for investors.

These ratings are often classified using three letters from AAA to D. The highest graded bonds are called investment grade bonds and are usually graded from AAA to BBB- ratings. These bonds are of the highest quality and are the least likely to default on a principal or interest payment during their life.

The more risky bonds, also known as junk bonds, are given a C or D rating. These junk bonds will have to pay more interest to investors to compensate them for the risk associated with the companies’ poor financial performance.

Some rating services use the same letter grades but use upper and lower-case letters. This rating system is taken into consideration by almost all investors since it indicates the likelihood that the issuer will default in a given period of time, either on interest or principal payment.

Example

Marlo Studios is a company that films commercial pieces for advertising agencies and individual companies. The company recently issued a series of bonds that were rated as BBB+. This means that the bonds are rated as investment quality bonds carrying relatively low risk.

This rating allows institutional investors to include Marlo Studio’s bond issue as part of their portfolios, as the rating show that the probability of a default is very low. This also means that Marlo will be not be required to pay as much interest on his bonds because the risk relatively low to investors.

On the other hand, if Marlo’s financial situation were to deteriorate, rating agencies will reevaluate this assessment and probably downgrade the bond to compensate for the additional risk. This downgraded rating would not only affect the market price of the bonds, it could also affect the interest associated with them on secondary markets.