The Bond Rating System

The bond rating system can be confusing because there are three separate but similar systems of rating bonds. We all hear of “AAA” rated bonds, and then know that last summer US bonds were downgraded to “AA”. But some may have seen a weird rating like “Aa1” on a bond or maybe “Caa2”. The key point of confusion is that there are three big rating agencies: Moody’s, Fitch and S&P.

Moody’s is distinct in that it has lower case letters and numbers in the ratings (e.g. Aaa, Aa1, B2, Caa2, etc.). All of Moody’s ratings have either a lower case number or a letter until you get to their lowest rating “C” which is the same as “D” for the other two companies’ rating systems – their rating for a bond that is in default. With Moody’s, for the number part of the rating, a higher number means the bond has a lower rating. Fitch and S&P’s rating systems are similar. They are in capital letters and can have a “+” or a “-“ attached to them similar to the grading system in school. When looking at one letter category, the more letters the higher the rating; “AAA” is higher than “AA”. The system ratings are virtually identical until you get to the lower quality bonds. S&P has more detail in the “C” ratings and will break it down as CCC+, CCC, CCC-, CC, C while Fitch only notes these bonds as “CCC”. Here is a chart that approximates the different companies’ bond ratings with one another:

Sometimes you’ll also hear the term “Investment Grade Bonds”. This is a term is defined as a bond rated BBB/Baa3 or higher. Often I’m asked how much riskier is BB than BBB. It’s impossible to say other than by statistical default rates. Unfortunately the line between “investment grade” and “non-investment grade” is somewhat arbitrary and it is not as though there is a dramatic difference between bonds right at the border of either side of this line. It’s just meant as an approximation of higher quality bonds and lower quality bonds. Frequently you’ll see these credit rating agencies rate bonds on either side of this line. Moody’s may give it a Baa3 but S&P gives it a BB. Or a very famous case is when the US lost its AAA rating. It was actually only S&P that dropped their rating down to “AA+” from “AAA”, but Fitch still rates US bonds as “AAA” and Moody’s rates US bonds as “Aaa” (their highest rating). In addition to this, rating companies will also say their outlook for the rating as positive, negative or stable. So even though S&P currently rates the US as “AA+”, their outlook is currently “positive”. However, Moody’s rating for the US is “Aaa” with a “negative” outlook.

It’s also important to note that sometimes bonds will be rated the same for different types of bonds. Just contrasting all municipal bonds versus all corporate bonds, if you look at the default rates of the bonds that S&P rated at BBB and eventually went into default, BBB corporate bonds are normally about 20-40 times more likely to default than BBB muni bonds. Naturally it changes year over year, but from a default risk standpoint, a BBB municipal bond and a BBB corporate bond are not the same thing.

The discussion of bond yields and price is for another day, but generally, the higher the yield the lower the credit quality. When you see bonds called “high yield” it also suggests a lower credit quality. “Junk bonds” are going to refer to very low credit quality; these may also be more kindly called “speculative grade bonds”.

For extra credit, here is a list of the countries that S&P rates as AAA (in alphabetical order):

1. 1. Australia
   2. Canada
   3. Denmark
   4. Finland
   5. Germany
   6. Hong Kong
   7. Liechtenstein
   8. Luxembourg
   9. Netherlands
   10. Norway
   11. Singapore
   12. Sweden
   13. Switzerland
   14. United Kingdom

And just for grins, here are some current very low rated countries (in backward rating order, I’ve excluded some countries):

1. 1. Greece (CC)
   2. Belarus (B-)
   3. Belize (B-)
   4. Ecuador (B-)
   5. Jamaica (B-)
   6. Pakistan (B-)
   7. Argentina (B)
   8. Lebanon (B)

None of the countries on this list should be terribly surprising. Countries with small and/or unstable economies are going to have lower ratings. Other countries of interest are:

1. 1. France (AA+)
   2. China (AA-)
   3. Israel (A+)
   4. Brazil (BBB)
   5. Russia (BBB)
   6. Mexico (BBB)
   7. Venezuela (B+)
   8. Egypt (B+)

Also the notorious PIIGS (in order of their pejorative acronym):

1. 1. Portugal (BB)
   2. Italy (BBB+)
   3. Ireland (BBB+)
   4. Greece (CC)
   5. Spain (A)

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availablility and change in price.