When to trust bond rating agencies

credit risk Moody Standard & Poor’s Fitch Rating
Investment grade —— —— ——
best quality what AAA AAA
high quality Aa1, Aa2, Aa3 AA+, AA, AA- AA+, AA, AA-
medium up A1, A2, A3 A+, A, A- A+, A, A-
Moderate Baa1, Baa2, Baa3 BBB+, BBB, BBB- BBB+, BBB, BBB-
Non-investment grade —— —— ——
Speculative medium Ba1, Ba2, Ba3 BB+, BB, BB- BB+, BB, BB-
Speculative lower grades B1, B2, B3 B+, B, B- B+, B, B-
Speculation risk Caa1 CCC+ CCC
Poor speculation Caa2 CCC ——
Near default Caa3, Ca CCC-, CC, C CC, CC
Default/Bankruptcy C D D


Each credit analyst will provide a slightly different method to assess the company’s creditworthiness. When comparing these types of bonds, it is a good rule to see if the bonds are investment grade or non-investment grade. This will provide the necessary foundation in a simple and clear way. However, investment grade bonds are not always a better investment.

As an asset class, bonds with low credit ratings actually have higher returns in the long run. On the other hand, their prices are more volatile. Crucially, individual bonds that are rated below investment grade are more likely to default. Bonds with low credit ratings are also called high-yield bonds or junk bonds.

It is important to remember that these are static ratings, because novice investors may be able to make long-term assumptions just by looking at them. For many companies, these ratings are always in dynamic change and are subject to change. This is especially true during difficult economic times, such as the 2008 financial crisis. When institutions make statements about their assessments, terms such as “credit watch” need to be considered. Credit Watch usually indicates that the company’s credit rating will be downgraded soon.

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Unfortunately, the downward path is much easier than the upward path. This is partly due to the way the system is designed. As part of its capital structure, a high-quality company is required to issue bonds. The investment-grade bond market has always dominated the high-yield market. This market structure prevents budding companies from entering the bond market unless they issue convertible bonds. Even larger companies must withstand constant scrutiny.

Use credit ratings for ETFs and mutual funds

Today, individual companies and their credit ratings are changing too fast to simply buy and hold individual corporate bonds. However, bond funds provide another approach for long-term investors. There are many mutual funds and exchange-traded funds (ETFs) that will hold large amounts of investment-grade or high-yield bonds for investors.

In a world where credit ratings change overnight, bond funds may be the best choice for passive investors.

Bond rating agencies made some outstanding mistakes during the 2008 financial crisis, but their judgments on asset classes were mostly correct. High-quality US Treasury ETFs soared to new highs in 2008, while overall bond ETFs rose slightly. Investment-grade corporate bond ETFs suffered losses that year, and junk bond ETFs suffered heavy losses. This is exactly what people expect based on credit ratings.

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When dealing with a large number of companies, the odds are mostly average, so bond rating agencies can be trusted here. It is still possible to buy and hold comprehensive bond ETFs without worrying about changes in ratings.

Active investors can also focus on asset classes instead of trying to figure out which individual bonds are undervalued. For example, junk bonds were undervalued after 2008 and generated considerable returns in subsequent years. Emerging market bonds sometimes follow a different model from other bond markets, so they can outperform the market under certain conditions. Remember, there is no need to place all bets on one category to beat the index. Investors can put 80% of their funds into overall bond ETFs, and only invest 20% of their funds into bond ETFs that they believe will outperform the broader market.

How the company evaluates the rating

For investors, reviewing credit ratings is important, but for companies it is even more important. Ratings affect companies by changing the cost of borrowing. A lower credit rating means that higher interest expenses lead to higher capital costs, which in turn leads to lower profitability. It also affects the way companies use capital. The interest paid is usually different from the dividend payment. The basic premise is that the borrower expects the return on the borrowed funds to be higher than the cost of funds.

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Over time, credit ratings will also have a profound impact on the company. The rating directly affects the liquidity of its bonds in the secondary market. The company’s ability to issue shares, the way analysts assess debt on the balance sheet, and the company’s public image are also affected by credit ratings.

Bottom line

History teaches us that we must first use information provided by credit rating agencies. Their method is time-tested, and until around 2008-2009, few people questioned it. Ratings are critical to the value of the company itself, because it may determine the company’s future.

As financial markets become more mature, opportunities for access to capital markets and scrutiny have increased. In addition to increased volatility, the loan market also has risks similar to those in the stock market. For today’s bond market investors, diversification through ETFs and mutual funds is both more practical and more important.

With the acceleration of financial information and market changes, bond ratings have become an indispensable decision-making tool. If you are considering investing in a specific bond, check the ratings and their trends. If you are unwilling to keep track of changes in ratings, mutual funds or ETFs can do it for you.


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