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A bond is issued by private and government firms to raise capital and many investors find it difficult to assess whether the company is more or less able to pay back the debt.
Rating is given by independent agencies like S&P, Moody and Fitch, who measure the credit quality of a particular bond to tell about the risks of investing in bonds, that it measures through the financial strength and ability to make an interest payment or repay the amount when due, of the company issuing it.
It is based on international financial reporting standards that use a combination of letters, numbers, and symbols to indicate the strength of the bond on the rating scale.
The rating system of each agency is different but a coveted triple-A shows the best and every issuer wants their offer to achieve triple-A.
The agencies use factors like -
• The strength of the issuer measured through a balance sheet that includes the total level of debt to GDP ratio.
• The current business conditions, profit margins, and earnings. A government issuer may rate one part based on the strength of the economy.
• The future outlook of the firm and the potential impact on the regulatory environment
• Ability to handle adversity and tax.
Letter involves a broad range of ratings and Moody uses the number to indicate the quality where Aa1 is considered the best which is followed by Aa2 and Aa3. S&P uses A+, A, A- (A1, A2, A3) rating for higher financial commitment and the ability to withstand a prolonged recession without losing to make a debt payment.
A bond that is upgraded to a better rating gains price and if it is downgraded the price falls.
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