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How Junk Bonds Work


Making the Grade: Junk Bond Ratings

How do you know whether you have a junk bond on your hands? You check out the rating -- the financial equivalent of a letter grade you get in school -- assigned by a ratings agency. The best known of these agencies include the following companies:

All these services use a report card-type letter system to rate bonds, with an AAA or Aaa being the best grade and a C or D being the worst, depending on which service reported the rating (see the chart below to compare them). Often you will see grades with additional + and - signifiers.

Standard & Poor's
Moody's
Fitch
­Grade
Risk
AAA Aaa AAA Investment Low
AA Aa AA Investment Low
A A A Investment
Medium
BBB Baa BBB Investment
Medium
BB Ba BB Junk
High
B B B Junk
High
CCC Caa CCC Junk
High
CC Ca - Junk
High
C - - Junk
High
D C DDD, DD, D
Junk
Default
­
It is important that the ratings are accurate and consider all factors to be fair to investors and issuers alike. Stella Kapur, a director at Standard & Poor's, explained in a podcast how her team arrives at their ratings. Among other things, they inspect the company's ability to repay debt. She and her team might ask the following questions:
  • Does the company have enough money to pay the promised interest rate payments?
  • How is the company's liquidity (or ease with which it can convert assets into fast money)?
  • How does the company's cash flow (or amount of money earned and spent, compare to the debt it has accrued)?
  • How much money does it cost to run the company successfully?
  • What are its future goals and strategies? How much will they cost to reach?
  • What industry is the company in? How does it compare to competitors?

Though a company may be ready to pay off its debts, it may not necessarily be willing, Kapur added. The willingness of a company can be assessed from its financial plans.

U.S. Government Bonds in the Junk Drawer?
Moody's Investors Service made headlines in January 2008 when analysts expressed concern over the creditworthiness of what is historically the most iron-clad of all investments: U.S. government bonds [source: Reuters]. The possible future expenses of Medicare and Social Security have frightened Steven Hess, a Moody analyst, into questioning the high rating of the bonds [source: Reuters]. Economist John Williams even suggested they be downgraded to junk-bond status to compensate for the weakening U.S. dollar [source: Corsi].

As you might guess, and Kapur seconded, the rating process cannot be boiled down to a simple formula; it takes practiced judgment to decide which factors should be considered more important than others, depending on the situation.

In addition, ratings are never set in stone. Newspapers constantly report that Standard & Poor's, Moody's or Fitch have downgraded or upgraded a bond rating. When one service makes a change, the others are likely seriously considering it. Standard & Poor's keeps a close eye on corporate news and changes ratings accordingly. In addition, if nothing newsworthy occurs, the service makes sure to review each rating at least once every three months. Listen to the podcast and learn more about the system by visiting Standard & Poor's Web site.

­­In addition to these ratings services, the U.S. Securities and Exchange Commission (SEC), which oversees the market, occasionally will investigate junk bonds. After Milken and Drexel were charged with securities fraud, the government began to investigate the legitimacy of junk bonds [source: Wallace].

Now that we understand how junk bonds get their ratings, we can make better decisions as to whether to get them and how to pick the best ones, which we'll discuss in the next section.