Definition as Credit Rating, Criteria, and Types of AAA Bonds
What Is a AAA Credit Rating?
AAA is the highest possible rating that may be assigned to an issuer’s bonds by any of the major credit rating agencies. AAA-rated bonds have a high degree of creditworthiness because their issuers are easily able to meet financial commitments and have the lowest risk of default. Rating agencies Standard & Poor’s (S&P) and Fitch Ratings use the letters “AAA” to identify bonds with the highest credit qualitywhile Moody’s uses a slightly different “Aaa” to signify a bond’s top-tier credit rating.
Key Takeaways
- The highest possible rating that a bond may achieve is AAA, which is only bestowed upon those bonds that exhibit the highest levels of creditworthiness.
- This AAA rating is used by Fitch Ratings and Standard & Poor’s, while Moody’s uses the similar “Aaa” lettering.
- Bonds that receive AAA ratings are viewed as the least likely to default.
- Issuers of AAA-rated bonds generally have no trouble finding investors, although the yield offered on these bonds is lower than other tiers because of the high credit rating.
Understanding AAA
Since AAA-rated bonds are perceived to have the lowest risk of default, these instruments tend to offer investors the lowest yields among bonds with similar maturity dates (lower risk = lower return). The term “default” refers to a bond issuer failing to fulfill its obligations, namely failing to make semi-annual interest payments or repay the principal amount when due.
AAA ratings are given to government debt and companies’ corporate bonds. The global credit crisis of 2008 resulted in a number of companies losing their AAA rating, most notably, General Electric. And as of September 2022, only two companies held the AAA rating outright—Microsoft (MSFT) and Johnson & Johnson (JNJ).Apple is split with a Aaa rating by Moody’s and a AA+ (one notch below AAA) from S&P.
Even the United States suffered a ratings cut by S&P to AA+ in 2012, losing it’s vaunted AAA status due to political infighting over raising the debt ceiling. Moody’s and Fitch maintained the US at Aaa and AAA ratings, respectively.
Rather than restricting their fixed income exposure to AAA-rated bonds, investors should consider balancing those investments with higher income-producing bonds, such as high-yield corporates.
Types of AAA Bonds
Municipal Bond Types
Municipal bonds can be issued either as revenue bonds or as general obligation bonds—with each type relying on different sources of income. Revenue bonds, for example, are paid using fees and other specific income-generating sources, like city pools and sporting venues. On the other hand, general obligation bonds are backed by the issuer’s ability to raise capital through levying taxes. Pointedly: State bonds rely on state income taxes, while local school districts depend on property taxes.
Secured vs. Unsecured Bonds
Issuers can sell both secured and unsecured bonds. Each type of bond carries with it a different risk profile. A secured bond means that a specific asset is pledged as collateral for the bond, and the creditor has a claim on the asset if the issuer defaults. Secured bonds may be collateralized with tangible items such as equipment, machinery, or real estate. Secured collateralized offerings may have a higher credit rating than unsecured bonds sold by the same issuer.
Conversely, unsecured bonds are simply backed by the issuer’s promise to pay. Therefore the credit rating of such instruments relies heavily on the issuer’s income sources and business outlook.
Benefits of a AAA Rating
A high credit rating lowers the cost of borrowing for the issuer (or borrower). Therefore, it stands to reason that companies with high ratings are better positioned to borrow large sums of money than fixed-income instruments with lesser credit ratings. And a low cost of borrowing affords firms a substantial competitive advantage by letting them easily access credit to grow their businesses.
For example, a business may use the incoming funds from a new bond issue to launch a new product line, set up shop in a new location, or acquire a competitor. All of these initiatives can help a company increase its market share, and thrive over the long haul.
Why is a credit rating so important?
The level of credit rating an issuer receives has significant implications on the cost of borrowing in the open market. The better the credit rating—with AAA being the best—the lower the cost to borrow and vice versa. For investors, you’ll need to balance the risk you’re willing to take against the yield you’re seeking.
Who decides what credit rating a debt issuer receives?
There are three major credit rating agencies: S&P, Moody’s, and Fitch. They assess a debt issuer’s creditworthiness and ability to pay interest and principal on bonds, based on multiple factors, such as the company’s cash flow, amount of other outstanding debt and the business outlook for the issuer, to name just a few criteria.
What does a AAA credit rating mean?
A AAA credit rating is only given to the most creditworthy debt issuers and allows investors to gauge the amount of risk in their fixed income portfolio. Conservative investors will typically sacrifice return or yield to own the highest credit rating issues available.
The Bottom Line
Credit ratings are assigned to debt issues and bonds by the three major debt rating agencies: S&P, Moody’s, and Fitch. Their credit ratings have a strong influence on the cost of borrowing for the issuer. The better the credit rating, the lower the cost to borrow. AAA /Aaa ratings are the highest ratings issued by the credit rating agencies and likely result in the lowest borrowing costs or yields. Investors seeking a better return should look down the credit ratings scale for bond issues with lower ratings and higher yields.