Bond Ratings Agency ratings are an integral part of the bond market because most corporate and municipal bonds are rated by one or more of the rating agencies. The exceptions are very small issues and bonds from certain industries, such as bank issues. These are known as nonrated bonds. There are three major rating agencies: (1) Fitch Investors Service, (2) Moody's, and (3) Standard and Poor's.

Bond ratings provide the fundamental analysis for thousands of issues. The rating agencies analyze the issuing organization and the specific issue to determine the probability of default and inform the market of their analyses through their ratings.9

The primary question in bond credit analysis is whether the firm can service its debt in a timely manner over the life of a given issue. Consequently, the rating agencies consider expectations over the life of the issue, along with the historical and current financial position of the company. We consider default estimation further when we discuss high-yield (junk) bonds.

Several studies have examined the relationship between bond ratings and issue quality as indicated by financial variables. The results clearly demonstrated that bond ratings were positively related to profitability, size, and cash flow coverage, and they were inversely related to financial leverage and earnings instability.10

The original ratings assigned to bonds have an impact on their marketability and effective interest rate. Generally, the three agencies' ratings agree. When they do not, the issue is said to have a split rating.11 Seasoned issues are regularly reviewed to ensure that the assigned rating is still valid. If not, revisions are made either upward or downward. Revisions are usually done in increments of one rating grade. The ratings are based on both the company and the issue. After an evaluation of the creditworthiness of the total company is completed, a company rating is assigned to the firm's most senior unsecured issue. All junior bonds receive lower ratings based on indenture specifications. Also, an issue could receive a higher rating than justified because of credit-enhancement devices, such as the attachment of bank letters of credit, surety, or indemnification bonds from insurance companies.

The agencies assign letter ratings depicting what they view as the risk of default of an obligation. The letter ratings range from AAA (Aaa) to D. Exhibit 18.3 describes the various ratings assigned by the major services. Except for slight variations in designations, the meaning and interpretation are basically the same. The agencies modify the ratings with + and - signs for Fitch and S&P or with numbers (1-2-3) for Moody's. As an example, an A+ (A1) bond is at the top of the A-rated group.

The top four ratings—AAA (or Aaa), AA (or Aa), A, and BBB (or Baa)—are generally considered to be investment-grade securities. The next level of securities is known as speculative bonds and includes the BB- and B-rated obligations. The C categories are generally either income obligations or revenue bonds, many of which are trading flat. (Flat bonds are in arrears

9For a detailed listing of rating classes and a listing of factors considered in assigning ratings, see "Bond Ratings" in The Financial Analysts Handbook, 2d ed., ed. Sumner N. Levine (Homewood, Ill.: Dow Jones-Irwin, 1988). For a study that examines the value of two bond ratings, see L. Paul Hsueh and David S. Kidwell, "Bond Ratings: Are Two Better Than One?" Financial Management 17, no. 1 (Spring 1988): 46-53. An analysis of the bond rating industry is contained in Richard Cantor and Frank Packer. "The Credit Rating Industry," Journal of Fixed Income 5, no 3 (December 1995): 10-34.

10See, for example, Ahmed Belkaoui, "Industrial Bond Ratings: A New Look," Financial Management 9, no. 3 (Fall 1980): 44-52; and James A. Gentry, David T. Whitford, and Paul Newbold, "Predicting Industrial Bond Ratings with a Probit Model and Funds Flow Components," The Financial Review 23, no. 3 (August 1988): 269-286.

11Split ratings are discussed in R. Billingsley, R. Lamy, M. Marr, and T. Thompson, "Split Ratings and Bond Reoffering Yields," Financial Management 14, no. 2 (Summer 1985): 59-65; L. H. Ederington, "Why Split Ratings Occur," Financial Management 14, no. 1 (Spring 1985): 37-47; and P. Liu and W. T. Moore, "The Impact of Split Bond Ratings on Risk Premia," The Financial Review 22, no. 1 (February 1987).

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