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Question:


Why do bonds have credit ratings? What does this mean?
-Derwin29


Answer:


A credit rating is simply an independent authority’s assessment of the ability of a borrower to pay back money it owes in full and on time. A key reason that such authorities are needed is that there are many more bond issues out there than stock issues. A company will have its common stock and maybe one or two issues of preferred stock, although some companies, like utilities, will have several preferred series. But a company can have dozens of bond issues, each potentially with a different rating because of its seniority. The most senior bonds – the ones that get paid first if there is a default – may have a higher rating than more subordinate debt.
 
Corporations that have publicly traded stock aren’t the only bond issuers, either. Unlisted companies also borrow. So do state, county and city governments, the U.S. and many foreign governments and various agencies like municipal water and sewage authorities. Bonds are issued to finance specific projects like power plants and toll roads, too, and they are assembled from various bits of paper like mortgages. Mortgage-backed bonds were a focal point of the 2008 financial crisis. All of this makes for a bewildering number of bond issues to keep track of. Because everybody can’t know everything, there are agencies – the three big ones are Standard & Poor’s, Fitch and Moody’s – that specialize in evaluating bonds and judging their creditworthiness. They don’t always do it well, as the implosion of supposedly sound mortgage-backed securities shows, yet they keep on keeping on. It’s a dirty job, but someone’s got to do it.

 

 

-Conrad de Aenlle



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