Which statement about bond ratings is true?

Which statement about bond ratings is true?

• A. Bonds are rated based on the issuer's default risk.
• B. Bond ratings are set by the issuer.
• C. Bond ratings do not consider default risk.
• D. Only government bonds are rated.

Answer: (A)

Bond ratings measure credit quality by assessing the issuer’s probability of default and the potential loss to investors if default occurs. That focus on default risk is why ratings are the primary tool for signaling how likely a bond is to pay interest and principal on time. Rating agencies analyze financial strength, cash flow, leverage, business risk, and other factors to translate that assessment into a letter-grade indication of risk, which in turn helps investors price the bond and determine required yields. The idea that ratings are set by the issuer is not correct—the issuer can request a rating, but an independent rating agency conducts the evaluation and assigns the rating. The notion that ratings do not consider default risk is also incorrect because default risk is exactly what ratings are designed to quantify. Finally, the claim that only government bonds are rated is false: ratings cover a wide range of issuers, including corporate and municipal bonds, not just government debt.

Bond ratings measure credit quality by assessing the issuer’s probability of default and the potential loss to investors if default occurs. That focus on default risk is why ratings are the primary tool for signaling how likely a bond is to pay interest and principal on time. Rating agencies analyze financial strength, cash flow, leverage, business risk, and other factors to translate that assessment into a letter-grade indication of risk, which in turn helps investors price the bond and determine required yields.

The idea that ratings are set by the issuer is not correct—the issuer can request a rating, but an independent rating agency conducts the evaluation and assigns the rating. The notion that ratings do not consider default risk is also incorrect because default risk is exactly what ratings are designed to quantify. Finally, the claim that only government bonds are rated is false: ratings cover a wide range of issuers, including corporate and municipal bonds, not just government debt.