What Financial Report Readers Should Know about Bond-Rating Agencies - dummies

What Financial Report Readers Should Know about Bond-Rating Agencies

By Lita Epstein

Financial report readers should become familiar with bond rating agencies. Bond ratings have a great impact on a company’s operations and the cost of funding its operations. The quality rating of a company’s bonds determines how much interest the firm has to offer to pay in order to sell the bonds on the public bond market.

Bonds that are rated with a higher-quality rating are considered less risky, so the interest rates that must be paid to attract individuals or companies to buy those bonds can be lower. Companies that issue bonds with the lowest ratings, which are also known as junk bonds, pay much higher interest rates to attract individuals or companies to buy those bonds.

Bonds are a type of debt for a company. The individual or company that buys a bond is loaning money to the company that it expects to get back. The firm must pay interest on the money that it’s borrowing from these bondholders.

You should be familiar with the three key rating agencies, where you can find out what bond analysts think:

  • Standard & Poor’s: Although S&P is well-known for the S&P 500, which is a collection of 500 stocks that form the basis for a stock market index (a portfolio of stocks for which a change in price is carefully watched), the company is also one of the primary bond raters. You can find more information at www.standardandpoors.com.

  • Moody’s Investor Service: Moody’s specializes in credit ratings, research, and risk analysis, tracking trillions of dollars in debt issued in the U.S. and international markets. In addition to its credit-rating services, Moody’s publishes investor-oriented credit research, which you can access at www.moodys.com.

  • Fitch Ratings: The youngest of the three major bond-rating services is Fitch Ratings. John Knowles Fitch founded Fitch Publishing Company in 1913, which began as a publisher of financial statistics. In 1924, Fitch introduced the credit-rating scales that are familiar today: AAA to D. Fitch is best known for its research in the area of complex credit deals and is thought to provide more rigorous surveillance on such deals.

Each bond-rating company has its own alphabetical coding for rating bonds and other types of credit issues, such as commercial paper (which are shorter-term debt issues than bonds).

Bond Quality Moody’s Standard & Poor’s Fitch
Best quality Aaa AAA AAA
High quality Aa AA AA
Upper medium grade A A A
Medium grade Baa BBB BBB
Speculative Ba BB BB
Highly speculative B B B
High default risk Caa or Ca CCC or CC CCC, CC, or C
In default C D DDD, DD, or D

Any company bonds rated in the “speculative” category or lower are considered to be junk bonds. Companies in the “best quality” category have the lowest interest rates, and interest rates go up as companies’ ratings drop. A key job of any firm’s executive team is to feed bond analysts critical financial data to keep the firm’s ratings high. Financial reports are one major component of that information.

Standard & Poor’s (S&P) makes its bond ratings publicly available with links on its website home page. You can search for information about any company’s debt ratings.

Whenever a change occurs in the ratings, the rating services issue a press release with an extensive explanation about why the rating has changed. These press releases can be an excellent source of information if you’re looking for opinions on the numbers you see in the financial reports. You can find these press releases on the bond-rating companies’ websites, as well as in news links on financial websites.

Regulations for bond-rating agencies changed after passage of the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010. The change became necessary after the failure of bond-rating agencies to properly rate mortgage securities.

Many people see the AAA ratings on bonds that later proved to be junk as a major contributing factor to the crash of 2008 and the collapse of Lehman Brothers. The 2010 legislation imposes new liability exposure on the credit rating agencies. They must improve their internal control requirements. They must also put barriers in place to address conflicts of interest issues.