 Personal Finance PowerPoint Presentation, Bond Rating. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Bond Rating which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated March 25th, 2020. In prior presentations, we've been looking at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a bond rating? A bond rating is a way to measure the credit worthiness of a bond which corresponds to the cost of borrowing for an issuer. These ratings typically assign a letter grade to bonds that indicates their credit quality. So from the investor side of things, if we're making investments, we typically want that diversified portfolio, meaning possibly some investments in equities or stocks, which could have a higher level of volatility but possibly higher possibility for gain, some in fixed income, which might include then bonds. Bonds we could basically think of as in essence, loaning money to the issuer of the bond, typically being the government or a corporation. The government bonds often being the ones that are like the baseline that we can kind of measure towards because the government bonds like US federal government bonds, for example, should have very low to almost zero default risk because you would think that the government would be able to service their debts given the fact that they can tax and they could basically print money. And then we might look at other kinds of bonds as comparisons to them and we're gonna want to know what the risk of, for example, default is related to those bonds and to help assist in that, we've got these credit bond ratings that can help us with that so that we can measure the risk involved and that, of course, will have an impact on what the market desires to pay for the bonds. If we're a market, we're investing, we have the choice of investing in something that has very little risk, like a government bond versus a corporate bond that has higher risk, we're gonna invest in the government bond, all else equal, then that means that if a corporation wants to generate money by issuing bonds, they're gonna have to generate or provide a higher return and those are the types of decisions that we make on the investment side of things. So private independent rating services such as standards and pours, Moody's Investors Service and Fitch Ratings Incorporated evaluate a bond issuers financial strength and its ability to pay a bond's principal and interest in a timely fashion. So obviously when you're trying to rate a bond, you're trying to look at the issuer of the bond, the one that's gonna have to pay the interest payments and the principal at the end and see if they can basically have the cash flow in order to do that, what's the likelihood they're not gonna default, meaning they're not gonna be able to pay the interest and or principal. So breaking down bond rating, most bonds carry rating provided by at least one of the following three chief independent rating agencies, those being one standards and pours, two Moody's Investors Services and three Fitch Rating Incorporated. Obviously you can look these up online if you so choose from U.S. Treasuries to International Corporations, these agencies conduct a thorough financial analysis of a bond's issuant body. So note the issuant body, we're thinking who's issuing the bonds, governments or corporations, note that like anything, these rating agencies are fallible, there have been times in the past, particularly in the Great Recession for example, when it seems that they didn't quite have a handle on the bond ratings as much as we would like, but clearly they're a good tool for the measurement of the credit worthiness or the ability for the issuers of the bonds to pay back the bonds. So based on each agency's individual set of criteria analysis determine the entity's ability to pay their bills and remain liquid while also taking into considerations of bonds future expectations and outlook. So the agencies then declare a bond's overall rating based on the collection of these data points. Bond ratings affect pricing, yield, and a reflection of long-term outlook. So bond ratings are vital to altering investors to the quality and stability of the bond in questions. These ratings consequently greatly influence interest rates, investment appetite and bond pricing. So clearly if you were on the issuer of the bonds side of things, the better rating that you can get than the more faith or trust that people will have that they can pay back and that will allow you to issue bonds, getting capital, getting money, getting financing at a cheaper rate. That's why the government, it's so important for governments like the US government for example, given the fact that they have the power to tax and the power to basically print money has so much faith at this point in time that the default risk is almost at zero. That allows the government to work and basically issue bonds at a rate that's lower than anybody else because of that faith that's there. Now obviously if you lose that faith then credit becomes a problem. It becomes a difficulty to get the financing. So when you look on the corporate side of things clearly they can't print money, they can't tax in order to service the debt. So they're gonna have to make sure that they have other measures to basically have a high likelihood to pay off the debts that will then be reflected hopefully on the ratings. So higher rated bonds known as investment grade bonds are viewed as safer and more stable investments. Such offerings are tied to publicly traded corporations and government entities that boost positive outlooks. Investment grade bonds contain triple A to triple B ratings from standard and pours and A, A, A, there's A to small A's to A, B, B, capital B to small A's three rating from Moody's investment grade bonds usually see bond yields increase as the ratings decrease. So they have a little bit different of categories so you can get into the different reporting or categories with the different agencies or rating agencies. Investment grade bonds usually see bond yields increase as ratings decrease, U.S. Treasury bonds are the most common triple A rated bond security. So that's why they're often used as kind of like the benchmark because again you would think there'd be little to no default risk on the U.S. government for example, bonds. So non-investment grade bonds, junk bonds usually carry standard and pours rating of B, B plus to D we've got the B double A one to C for Moody's. In some cases, bonds of this nature are given quote not rated in quote status although bonds carry these ratings are deemed to be higher risk investments, they nevertheless attract certain investors who are drawn to the high yields they offer. So again, if you're talking to a company that can't even get a rating or the ratings are quite low they're in the junk bond area, the only way they're gonna get financing through issuing bonds is to issue it with a greater return. They're gonna have to pay more basically rent on the money otherwise people would just buy other bonds that can attract certain people that are looking for the higher returns on the bonds. So but some junk bonds are saddled with liquidity issues and can feasibly default leaving investors with nothing. So obviously if they ran out of business or something like that you should get paid before they pay the stockholders but they might have to pay their other liabilities and obligations before they pay the bondholders if they were to liquidate and that would be a problem. So now you're taking on the risk oftentimes with those junk bonds or those lower rated bonds possibly similar to you might be looking at the stock market, right? Because you're trying to do the same thing at that point, you're trying to get a bigger return by taking on more risk and the whole point oftentimes of a balanced portfolio between bonds and stocks is to use the bonds to mitigate the risk that you're exposed to when you're on the equity side of the portfolios. So a prime example of non-investment grade bond was that issued by the Southwestern Energy Company which standard and pours assigned a BB plus rating reflecting its negative outlook. So independent rating agencies get tripped up in 2008 downturn. So this was a recession that took place and the rating agencies is a lot of people you can blame. There's a whole lot of blame that can go on in terms of who's at fault for the recession but obviously many things kind of went wrong. And part of that was a loss of faith in things like the rating agencies, like the banks and like the government's ability not to bail things out. In other words, big companies seem like they're started to play on a different kind of playing field not having the same kind of risk as others and that loses makes people kind of lose faith in the system which was a big problem in that particular turn down. So many Wall Street watchers believe that the independent bond rating agency played a pivotal role in contributing to the 2008 economic downturn. In fact, it came to light that during the lead up to the crisis, rating agencies were bribed to provide falsely high bond ratings thereby influencing their worth. Obviously that would give a whole lot of distrust to the rating agencies that everybody basically depends on to have some transparency, to have valid information about the bonds. They're supposed to be independent third party. That would be like some of the crisis as we've seen in the past when you've got auditors of the publicly traded companies colluding with the companies to provide good audit reports even though, right? So that kind of stuff rocks the faith in the system which is part of the reason that the US system is able to generate so much capital due to the faith in the system, the transparency in the reporting and so on. So one example of this fraudulent practice occurred in 2008 when Moody's downgraded 83% of $869 billion in mortgage backed securities which were given a rating of AAA just the year before. In short, long-term investors should carry the majority of their bond exposure in more reliable income producing bonds that carry investment grade bond ratings. So typically most investors want the solid bonds because they're generally using them to balance out the risk of the stocks. And therefore you don't want your bonds typically to be at risk unless you know specifically what you're doing. Speculators and distressed investors who make a living off of high-risk, high-reward opportunities should consider turning to non-investment grade bonds.