Principles of Managerial Finance

278 PART 2 Important Financial Concepts

a “Net Chg.” of 1.75 is given in the final column, the bond must have closed at

102 or $1,020 (102.00%$1,000) on the prior day. Its price decreased by 1.75,

or $17.50 (1.75%$1,000), on Tuesday, April 22, 2002. Additional informa-

tion may be included in a bond quotation, but these are the basic elements.

Bond Ratings

Independent agencies such as Moody’s and Standard & Poor’s assess the riskiness

of publicly traded bond issues. These agencies derive the ratings by using finan-

cial ratio and cash flow analyses to assess the likely payment of bond interest and

principal. Table 6.2 summarizes these ratings. Normally an inverse relationship

exists between the quality of a bond and the rate of return that it must provide

bondholders: High-quality (high-rated) bonds provide lower returns than lower-

quality (low-rated) bonds. This reflects the lender’s risk-return trade-off. When

considering bond financing, the financial manager must be concerned with the

expected ratings of the bond issue, because these ratings affect salability and cost.

Popular Types of Bonds

Bonds can be classified in a variety of ways. Here we break them into traditional

bonds (the basic types that have been around for years) and contemporary bonds

(newer, more innovative types). The traditional types of bonds are summarized in

terms of their key characteristics and priority of lender’s claim in Table 6.3. Note

TABLE 6.2 Moody’s and Standard & Poor’s Bond

Ratingsa

Standard

Moody’s Interpretation & Poor’s Interpretation

Aaa Prime quality AAA Bank investment quality

Aa High grade AA

A Upper medium grade A

Baa Medium grade BBB

Ba Lower medium grade BB Speculative

or speculative B

B Speculative

Caa From very speculative CCC

Ca to near or in default CC

C Lowest grade C Income bond

D In default

aSome ratings may be modified to show relative standing within a major rating category; for exam-

ple, Moody’s uses numerical modifiers (1, 2, 3), whereas Standard & Poor’s uses plus () and

minus () signs.

Sources:Moody’s Investors Service, Inc. and Standard & Poor’s Corporation.

Hint Note that Moody’s has
9 major ratings; Standard &
Poor’s has 10.