Before a bond is issued, it is rated according to its creditworthiness. How creditworthy a bond is depends mostly on how creditworthy the issuing company is, based on an assessment of the likelihood that the issuer may default on its debt payments. Private ratings services, such as Standard & Poor’s, Moody’s Investors Services, and Fitch Ratings, are hired by the issuing company to assess its financial strength. An agency’s evaluation of a company’s ability to pay a bond’s principal and interest in a timely fashion will determine the bond’s coupon rate. The higher the ratings service’s grade, the lower the perceived risk, and thus, the lower the coupon rate on the bonds.
Bond ratings are expressed as letters ranging from AAA to D. A triple-A rating is the most desirable, representing an investment-grade bond with the lowest level of credit risk. The rankings go down in grade (AAA to AA) and by notch (AA+ to AA). Many mutual funds and investment advisers only invest in bonds that are considered to be investment grade. To be considered investment grade, a corporate bond must be rated at least BBB- by S&P and Fitch, or Baa3 by Moody’s. Bonds below investment grade may be called high-yield bonds, speculative bonds, or junk bonds.
Each of the services uses the same basic grading system, with some variations in style. Here is a summary:
