Just as individuals have their own credit report and rating issued by credit bureaus, bond issuers generally are evaluated by their own set of ratings agencies to assess their creditworthiness. There are three main ratings agencies that evaluate the creditworthiness of bonds: Moody’s, Standard & Poor’s, and Fitch. DBRS is a Canadian ratings agency that also evaluates the creditworthiness of bonds. The agencies’ opinions of that creditworthiness – in other words, the issuer’s financial ability to make interest payments and repay the loan in full at maturity – is what determines the bond’s rating, and also affects the yield the issuer must pay to attract investors. Lower-rated bonds generally offer higher yields to compensate investors for the additional risk they carry.
How bond ratings work
Ratings agencies research the financial health of each bond issuer (including issuers of provincial and municipal bonds) and assign ratings to the bonds being offered. Each agency has a similar hierarchy to help investors assess a bond’s credit quality compared with other bonds.
Investors typically group bond ratings into two major categories:
|Bonds with a rating of BBB- (on the Standard & Poor’s, Fitch and DBRS scale) or Baa3 (on Moody’s) or better are considered “investment grade.”||Bonds with lower ratings are considered “speculative” and often referred to as “high-yield” or “junk” bonds.|
|Investment grade||Moody’s||Standard & Poor’s||Fitch||DBRS|
|Non-investment-grade||Moody’s||Standard & Poor’s||Fitch||DBRS|
|Weakest||Moody’s||Standard & Poor’s||Fitch||DBRS|
Sources: Fitch, Moody’s, Standard & Poor’s and DBRS.
Moody’s, Standard & Poor’s, Fitch and DBRS append an indicator to their ratings to show a bond’s ranking within a category. Moody’s uses a numerical indicator. For example, A1 is better than A2 (but still not as good as Aa). Standard & Poor’s, Fitch and DBRS use a plus or minus indicator. For example, A+ is better than A, and A is better than A-.
Remember that ratings are not perfect, and they can’t tell you whether or not your investment will go up or down in value. Before using ratings as a factor in your investment selection process, learn about the methodologies and criteria each ratings agency employs. You might find some methods more useful than others.
Investment-grade and high-yield bonds
You need to have a higher tolerance for potential risk to invest in high-yield bonds than you do for investment grade.
Because the financial health of an issuer can change – no matter if the issuer is a corporation or a government – ratings agencies can downgrade or upgrade a rating. It is important to monitor a bond’s rating regularly. If a bond is sold before it reaches maturity, any downgrades or upgrades in the bond’s rating can affect the price others are willing to pay for it.