Junk bond ratings are determined on the basis of a company’s ability to repay its debt obligations. In an assessment of a company’s creditworthiness, financial analysts may consider current assets and liquidity, cash flow, and reported performance in recent financial statements. They constantly adjust credit ratings to reflect changes in company circumstances and market conditions. If a company looks like it is likely to go into default, it can be downgraded, while firms with improving financial circumstances may be upgraded.
Several firms rate companies for the benefit of investors who want to determine if their bonds are safe buys. By policy, some financial institutions are not allowed to invest in so-called “junk bonds” with an extremely low credit rating, because they pose too much risk. This can include banks as well as government agencies that participate in investments. Such ratings can have an important impact on investor and consumer confidence. Very specific standards and procedures are used for junk bond ratings to keep them consistent and fair for the benefit of the general public as well as entities under evaluation.
Financial analysts considering junk bond ratings usually start by looking at financial records. They want to know what kinds of assets a company has, and specifically which represent liquid sources of capital that can be used to manage debt obligations. Overall cash flow is another consideration that can influence creditworthiness. Analysts can also evaluate financial obligations such as service on other debts as well as operating expenses. This information is available on public reports companies and agencies need to provide to interested parties.
Additionally, junk bond ratings may consider current economic conditions, which could be a factor in whether a company or municipality will be able to repay bonds. For example, a city might be counting on revenue from taxes to keep up with interest payments for a bond. Economists might note that revenues will probably fall and the city might have trouble with the interest as well as the eventual principal repayment, when it comes due.
The industry a company is in can be a concern with junk bond ratings; analysts can look at overall industry performance as well as the company’s standing. In the case of a car company preparing to sell bonds, for example, growth in the car industry paired with a strong reputation for the individual company can be good signs. If the company is struggling to make sales targets, however, it could have difficulty with its debt obligations, including bonds.