Types of Bonds
A bond issuer’s ability to pay its debts—that is, make all interest and principal payments in full and on schedule—is a critical concern for investors. Most corporate bonds are evaluated for credit quality by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. These credit rating agencies research and analyse issuers and assign a rating based on the credit quality. This in depth analysis is reviewed periodically and the rating may be upgraded or downgraded on the basis of changes in the operating or financial condition of the issuer.
The ratings agencies also have a section of their business that focuses on ratings for banks. Because banks are so important to the financial system, regulators and investors pay very close attention to these ratings for “financial” institution corporate bonds. Some corporate indices and other data sets even separate out investment grade corporate bond debt from financial investment grade corporate bond debt.
A variety of events or occurrences that can affect the ability of an issuer to repay the principal and interest on its debt may cause a bond’s rating to change. These can include changes in the economy or business climate, demographic changes within a jurisdiction, an acquisition or management changes, an increase or decrease in tax rates or projected revenues, or regulatory changes. Investors face “event risk” on corporate bonds which is the risk that a credit rating will be downgraded because of something over which no one has control. In fact, investors concerned about event risk with corporate issuers have been instrumental in forcing some issuers to provide some protection for investors in the form of higher coupon interest rate if ratings go down.
Credit ratings are one of a number of factors that are used to assess an investment. Investors also assess whether the credit rating agencies’ ratings are in fact reflective of the credit quality of the issuer. In addition to the credit rating providing an indication of what the credit agencies think about how the investment should be rated, the market of investors—individual and institutional—also indicates what is collectively thought of the rating as to its accuracy or reflection of the credit quality of the issuer and about other factors used to assess creditworthiness and risk in a corporate bond issue. Consulting with a broker or taking financial advice may be useful here.
For investors, here are some things to consider when a bond’s rating is raised or lowered:
Q: Who rates bonds?
A: Rating agencies rate bonds. They are private companies that evaluate a bond issuer’s financial health and assess its ability to repay its obligations in a timely manner. A rating is an evaluation of the likelihood that an issuer will repay the principal and interest of a particular bond on time and in full. Major rating agencies are Moody’s; Standard & Poor’s; Fitch Ratings.
Learn more about how Standard & Poor’s analyses banks and financial institutions’ credit quality as well as how it analyses insurers’ financial strength and its corporate criteria ratings.
Q: What will happen to my bonds if the rating is downgraded? Upgraded?
A: Investors’ perception is key. In many instances, the price of your bonds will go down when their credit ratings are lowered. This is not always the case, however, because prices are determined by investors in the marketplace and investors consider many factors other than ratings in making investment decisions. For that reason, bond prices can also change prior to a rating action as investors make their own assessments of the changing risks. Alternatively, of course, when a credit rating is raised, the price of your bond could go up.
Q: Will owning an insured bond help?
A: Financial guaranty insurance can provide an additional measure of protection against credit risks. A bond insurer guarantees timely payment of principal and interest in the event of a default. As a result, insured bonds usually carry the highest credit rating, or Triple-A, and are thus not usually as affected by changes in the issuers’ credit rating-- recent market conditions have demonstrated that there are exceptions. In Europe, the financial guaranty insurance sector and the market for insured or “wrapped” bonds, have grown rapidly, although were affected by the market turmoil of 2007. Bond insurers also provide guarantees in mortgage and asset backed securities. Pension reform efforts in Europe are expected to increase the demand for bond insurance because insuring the complex pension financing structures can increase investor confidence and impact the credit quality of the bonds issued as well.
The use of financial guaranty insurance is growing in Europe and is usually purchased by bond issuers at the time bonds are initially sold. Such insurance is not available for purchase by individual investors.
Q: Should I sell my bonds when they are downgraded?
A: When a bond’s rating is downgraded, investors should assess whether the problem is temporary or longer term. You should also determine your risk tolerance and review your investment strategy. Your investment advisor can help you determine if the bonds still fit your investment objectives. See also Your Bond Investment in Turbulent Markets.
Q: How can I monitor the bonds’ rating and find out about any rating changes?
A: The following chart describes common bond ratings:
|Very Speculative||Caaa, Caa||B, CCC, CC, C||B, CCC, CC, C|
|Default||Ca, C||D||DDD, DD, D|
Ratings agencies make bond ratings and warnings of potential rating changes known by issuing press releases and posting the information on their web sites.
Bond issuers are also required to publicly disclose information that could potentially affect their securities. If such an event occurs, it will usually be reported in the financial or general press. Your financial advisor or broker can also be a source of information.
Checking a bond’s rating before buying is not only smart but also simple: Just ask your financial advisor. Bonds rated BBB or higher by Standard & Poor’s and Fitch Ratings, and Baa or higher by Moody’s, are widely considered “investment grade.”