When issuing a bond or credit rating, a rating agency gives its opinion on the bond or other security’s quality and creditworthiness – in other words, how likely the issuer is to make principal and interest payments on time. In determining a rating, the rating agency reviews the issuer’s financial reports, tax structure and related laws, demographic data, and economic statistics, among other things.
Bond ratings are divided into two general categories: investment grade and non-investment grade. Investment grade bonds have been judged relatively likely to pay principal and interest on schedule; non-investment grade bonds, or junk bonds, by contrast, have a higher risk of falling behind schedule or not making payments at all.
The three major rating agencies are:
- Moody’s Investors Service
- Standard and Poor’s (S&P)
- Fitch Ratings.
The ratings are:
- Investment Grade
- Non-Investment Grade
They break down as follows:
Investment Grade:
- Aaa/AAA - highest rate: lowest risk of default
- Aa/AA - high quality with low risk
- A - upper-medium grade with low risk
- Baa/BBB - medium grade, could have speculative characteristics
If a rating agency judges that an issuer has become less likely or able to make payments on its bonds – revenue shortfalls require an issuer to spend its reserves, for example – the rating agency may downgrade the issuer’s rating one or more levels.