Before a bond is issued, it is rated according to its creditworthiness. The more creditworthy a bond is, the less likely the issuer is to default on its debt payments. Rating agencies, 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 rating agency’s grade, the lower the perceived risk, and thus, the lower the coupon rate on the bonds.
The S&P and Fitch 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 least credit risk. The rankings go down by grade (AAA to AA) and by notch (AA+ to AA). Many mutual funds and investment advisors 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, speculative, or junk bonds.
Each of the rating services uses the same basic grading system, with some variations in style. Here is a summary:
