Factors

• The primary factor in a bond credit rating is the likelihood of default. The rating agency uses tests that apply different industry, economic, company management and product performance scenarios to the financial profile of the bond issuer. Increasingly negative test scenarios determine the issuer's appropriate credit rating level. A secondary factor is the repayment priority ranking of the specific bond in the event of default. A third factor is the issuing company's history of payments, demonstrated capability in overcoming past difficulties and corporate philosophy on risk taking. The fourth factor evaluates industry default patterns.
  
  

Implications

• Ratings on bonds imply the creditworthiness of the issuers and whether repayment is secured by company assets. The higher the rating, the more likely repayment is backed by verifiable assets such as buildings or machinery. This means that if the company stops paying interest or cannot repay the principal when it is due, the bond will be declared in default and the underlying assets will be sold to pay the investors.
  
  This does not mean you will receive your full investment back. That depends upon the liquidation value of the asset. If the company's credit or underlying assets decline in value, the company will be asked to add more assets. Under these circumstances ,the rating agencies may place the issuer on the watch list or lower the rating, which results in a drop in the market value of the bond. If the rating is raised, the market value of the bond will increase.
  
  

Significance

• Ratings signify the issuer's history of timely payments of interest and principal as well as its likelihood of maintaining financial health adequate to enable it to meet its payment obligations. Ratings also reflect the issuer's vulnerability to adverse economic conditions, seasonal factors or adverse industry trends. Certain types of bonds such as fully collateralized first mortgage bonds are highly rated, but unsecured debentures, senior subordinated debentures and subordinated debentures, receive lower ratings according to their repayment protection in the event of default, relative to other outstanding bonds by the same issuer.
  
  

Rating Levels

• Investment grade ratings are Aaa/AAA, Aa/AA, A/A and reflect bonds issued by the U.S. Treasury, municipal or corporate issuers that are extremely unlikely to default on payments of interest and principal. The investment grade rating Baa/BBB is considered slightly speculative because the issuer could be vulnerable to default under certain rare circumstances or provisions in the bond indenture limit asset protection in the event of default.
  
  Speculative or junk bond ratings are Ba/BB, B/B, Caa/CCC, Ca/CC, and C/C. These refer to bonds issued by financially insecure issuers where default is a strong possibility if not highly likely.
  
  

Application

• An individual attempting to use bond credit ratings in making an investment choice should only consider investment grade bonds rated Baa/BBB or higher.