CP

Development Bonds Some companies may be in a position to benefit from the sale

of either development bondsor pollution control bonds.State and local govern-

ments may set up both industrial development agenciesand pollution control agencies.

These agencies are allowed, under certain circumstances, to sell tax-exempt bonds,

then to make the proceeds available to corporations for specific uses deemed (by Con-

gress) to be in the public interest. Thus, an industrial development agency in Florida

might sell bonds to provide funds for a paper company to build a plant in the Florida

Panhandle, where unemployment is high. Similarly, a Detroit pollution control

agency might sell bonds to provide Ford with funds to be used to purchase pollution

control equipment. In both cases, the income from the bonds would be tax exempt to

the holders, so the bonds would sell at relatively low interest rates. Note, however,

that these bonds are guaranteed by the corporation that will use the funds, not by a

governmental unit, so their rating reflects the credit strength of the corporation using

the funds.

Municipal Bond Insurance Municipalities can have their bonds insured, which

means that an insurance company guarantees to pay the coupon and principal pay-

ments should the issuer default. This reduces risk to investors, who will thus accept

a lower coupon rate for an insured bond vis-à-vis an uninsured one. Even though

the municipality must pay a fee to get its bonds insured, its savings due to the lower

coupon rate often makes insurance cost-effective. Keep in mind that the insurers are

private companies, and the value added by the insurance depends on the creditwor-

thiness of the insurer. However, the larger ones are strong companies, and their own

ratings are AAA. Therefore, the bonds they insure are also rated AAA, regardless of

the credit strength of the municipal issuer. Bond ratings are discussed in the next

section.

Bond Ratings

Since the early 1900s, bonds have been assigned quality ratings that reflect their prob-

ability of going into default. The three major rating agencies are Moody’s Investors

Service (Moody’s), Standard & Poor’s Corporation (S&P), and Fitch Investors Ser-

vice. Moody’s and S&P’s rating designations are shown in Table 4-1.^14 The triple- and

double-A bonds are extremely safe. Single-A and triple-B bonds are also strong

enough to be called investment grade bonds,and they are the lowest-rated bonds

that many banks and other institutional investors are permitted by law to hold.

Double-B and lower bonds are speculative, or junk bonds.These bonds have a

172 CHAPTER 4 Bonds and Their Valuation

TABLE 4-1 Moody’s and S&P Bond Ratings

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

Note: Both Moody’s and S&P use “modifiers” for bonds rated below triple-A. S&P uses a plus and minus system;

thus, Adesignates the strongest A-rated bonds and Athe weakest. Moody’s uses a 1, 2, or 3 designation, with

1 denoting the strongest and 3 the weakest; thus, within the double-A category, Aa1 is the best, Aa2 is average,

and Aa3 is the weakest.

(^14) In the discussion to follow, reference to the S&P code is intended to imply the Moody’s and Fitch’s codes
as well. Thus, triple-B bonds mean both BBB and Baa bonds; double-B bonds mean both BB and Ba bonds;
and so on.

168 Bonds and Their Valuation