Measuring the Quality of Bond Issuers
Credit ratings are an important tool used to assess the ability of a bond issuer to make timely payments of interest and principal. Before you invest, your Financial Advisor can help you review a bond's credit rating, as well as the effect a rating change may have on the bond.
US Treasury securities, which are backed by the full faith and credit of the federal government, are accepted within the investment community as the benchmark against which the credit quality of all other fixed income securities is measured.
Rating Agencies: An Overview
A key risk of bond investing is credit risk, which is the possibility that a bond issuer will not be able to make scheduled interest payments or repay the principal when the bonds mature. There are three major credit ratings agencies—Moody's Investors Service, Standard & Poor's Corporation and Fitch Ratings—that review and rate an issuer's overall financial condition, as well as the industry or sector in which it operates, to determine creditworthiness. The resulting rating represents the agency's opinion at a particular point in time, and it is continuously revised to reflect any industry, sector, company or municipal developments that could affect a security's market price.
There are limitations to credit ratings. For example, they do not take future events and developments into consideration. As a result, investors should not rely solely on them when evaluating a potential bond investment.
How Bonds Are Classified
Rating agencies classify issuers and their bonds into two general categories: investment grade and below investment grade.
- Investment grade bonds are considered likely to meet their obligations and have a low probability of default. As a result, the issuer will generally pay a lower interest rate to access capital than will borrowers with a riskier credit profile. Investment grade bonds are generally more appropriate for conservative investors.
- Below investment grade bonds are often referred to as high yield or junk bonds and have speculative characteristics. The yields on these bonds are generally higher to compensate investors for the additional risk and, as a result, may be suitable only for aggressive investors willing to accept greater degrees of credit risk.
The Relationship Between Credit Ratings and Risk of Default
There is an inverse relationship between credit quality and the default probability of a bond; in general, the higher a security's credit rating, the lower its risk of default. Conversely, lower rated bonds will have higher relative yields, but the greater return potential is accompanied by an increased chance of a ratings downgrade and/or default.
|Investment Grade|| Rating |
| Highest Grade/Best Quality |
| Moody's || These obligations are judged to be of the highest quality, with minimal credit risk. || Aaa |
| S&P || The obligor's capacity to meet its financial commitment on the obligation is extremely strong. || AAA |
| Fitch || Highest credit quality; denotes the lowest expectation of default risk. Exceptionally strong capacity for payment of financial commitments. || AAA |
| High Grade/High Quality |
|Moody's || These obligations are judged to be of high quality and are subject to very low credit risk. || Aa1 |
| S&P || The obligor's capacity to meet its financial commitment on the obligation is very strong, differing from the highest-rated obligations only to a small degree. || AA+|
| Fitch || Very high credit quality; denotes expectations of very low default risk. Very strong capacity for payment of financial commitments.|| AA |
| Upper Medium Grade |
|Moody's || Obligations rated A are considered upper-medium grade and are subject to low credit risk. || A1|
| S&P || The obligor has strong capacity to meet its financial commitments; however, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than higher rated obligators. || A+|
| Fitch || High credit quality; denotes expectations of low default risk. The capacity for payment of financial commitments is considered strong. || A |
|Medium Grade |
| Moody's || These obligations are subject to moderate credit risk. They are considered medium-grade and as such may possess certain speculative characteristics. || Baa1|
| S&P || Adequate capacity to meet financial commitments. Adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. || BBB+ |
| Fitch || Good credit quality; denotes that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity. || BBB |
|Below Investment Grade|| Rating |
| Speculative Grade |
| Moody's || These obligations are judged to have speculative elements and are subject to substantial credit risk. || Ba1 |
| These obligations are considered speculative and are subject to high credit risk || B1|
| S&P ||Less vulnerable to nonpayment than other speculative issues; however, the obligor faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions which could lead to inadequate capacity to meet its financial commitment. ||BB+|
|More vulnerable to nonpayment than obligations rated BB, but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial or economic conditions will likely impair that capacity. ||B+|
| Fitch ||Speculative. An elevated vulnerability to default risk, particularly as a result of adverse changes in business or economic conditions over time. ||BB |
|Highly speculative. Material default risk is present, but a limited margin of safety remains. ||B |
|Highly Speculative Grade ||Moody's ||These obligations are judged to be of poor standing and are subject to very high credit risk. ||Caa1 |
|These obligations are highly speculative and are likely to be in, or very near, default, with some prospect of recovery of principal or interest. ||Ca |
|S&P ||The obligor is currently vulnerable to nonpayment, and is dependent upon favorable business, financial or economic conditions for the issuer to meet its financial commitments. ||CCC+|
|The obligation is currently highly vulnerable to nonpayment. ||CC |
|The obligation is currently highly vulnerable to nonpayment. May be used where a bankruptcy petition has been filed, or where cash payments have been suspended. ||C |
| Fitch ||Default is a real possibility. ||CCC |
|Default of some kind appears probable. ||CC |
|Default is imminent or inevitable. ||C |
|Moody's ||These bonds are typically in payment default, with little prospect for recovery of principal or interest. ||C |
|S&P ||The issuer has selectively defaulted on a specific issue. ||SD |
|General default. ||D |
| Fitch ||These obligations are in payment default. ||D |
Source: Standard & Poor's, Moody's Investors Service, Fitch Ratings
|Expected/Preliminary Ratings |
|Moody's||Expected Ratings are intended to anticipate Moody's forthcoming rating assignments, based on information from third party sources. The ratings will exist only until Moody's confirms the Expected Rating, or issues a different rating.||e|
|Moody's will assign a provisional rating when it is highly likely that the rating will become final after all documents are received, or an obligation is issued into the market.||p|
| Fitch ||Expected Rating: A preliminary rating, usually contingent upon the final documents, has been assigned.||Expected |
|Moody's ||This rating was initiated by Moody's and was not requested by the issuer. || unsolicited |
| S&P ||Unsolicited ratings are those ratings assigned at the initiative of S&P and not at the request of the issuer. || unsolicited|
|Moody's || NR is assigned to an unrated issuer, obligation and/or program.|| NR|
| S&P ||No rating has been requested, or there is insufficient information on which to base a rating.|| NR|
| Moody's ||The rating has been withdrawn. Reasons for withdrawal include: debt maturity, calls, puts, conversions, etc., or business reasons (e.g. change in the size of a debt issue), or the issuer defaults. || WR|
| S&P ||The rating has been withdrawn and the issuer or issuer is no longer rated by Fitch.|| WR |
| Moody's ||An obligor has failed to pay one or more of its financial obligations when due. Assigned when S&P believes the obligor has selectively defaulted on a specific class or issue, and will continue to meet payments on other issues/classes in a timely manner. || WR|
| S&P ||Restricted default; the issuer has experienced an uncured payment default on a bond, loan or other material financial obligation but which has not entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure, and which has not otherwise ceased business.|| WR|
| S&P ||This rating reflects a company that is under regulatory supervision. || R|
Source: Moody's Investors Service, Standard & Poor's, Fitch Ratings
Adjustments in Credit Quality
The agencies monitor the credit quality of the securities and issuers they have previously rated. When they determine that a rating change may be warranted, the security or issuer is placed on the "Watchlist" (Moody's), "CreditWatch" (S&P) or "Rating Watch" (Fitch).
|Rating Agency||Possible Upgrade||Possible Downgrade||Direction Uncertain|
|Moody's ||Upgrade (+)||Downgrade (-)||Uncertain (*) |
|S&P ||Positive||Negative ||Developing|
|Fitch ||Positive||Negative|| Evolving |
Source: Standard & Poor's, Moody's Investors Service, Fitch Ratings
Consider the Risks
In addition to credit risk, fixed income securities are subject to interest rate risk, call risk and reinvestment risk.
- Interest Rate Risk. The risk that the market value of securities in your portfolio might rise or fall due to changes in prevailing interest rates. All else being equal, if interest rates fall, bond prices will rise and vice versa.
- Reinvestment Risk. The risk that the income stream from a given investment may be reinvested at a lower interest rate.
- Liquidity Risk. Liquidity is a measure of how easily a security can be sold in a secondary market, and fixed income securities can range from highly liquid to relatively illiquid. Morgan Stanley provides access to the secondary market, if you wish to sell your bonds prior to maturity. The level of liquidity can vary between bond issues, however, and the price you receive may be more or less than the par value or your original purchase price. Lower rated securities are generally less liquid than investment grade securities.
The market value of bonds may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value, due to changes in market conditions or changes in the credit quality of the issuer. Talk to your Financial Advisor about your investment goals and risk tolerances when considering fixed income securities in your portfolio.
For more information about bond credit ratings, ask your Financial Advisor for a copy of our brochure "Bond Perspectives: An Educational Look at Bond Credit Ratings."