What methods can you use to assess the creditworthiness of bond issuers?

1 Credit ratings

One of the most common and widely used methods to assess the creditworthiness of bond issuers is to look at their credit ratings. Credit ratings are opinions issued by independent agencies, such as Standard & Poor's, Moody's, and Fitch, that reflect the ability and willingness of bond issuers to meet their financial obligations. Credit ratings are based on various factors, such as the issuer's financial performance, industry outlook, competitive position, governance, and regulatory environment. Credit ratings are usually expressed by letters, such as AAA, AA, A, BBB, BB, B, and so on, with higher ratings indicating lower default risk and higher credit quality.

2 Financial ratios

Calculating and comparing financial ratios is another way to assess the creditworthiness of bond issuers. Financial ratios are numerical indicators that measure the financial health, performance, and efficiency of bond issuers. For example, the debt-to-equity ratio shows the proportion of debt and equity used to finance assets and a high ratio implies a high leverage and a low solvency. The interest coverage ratio reveals how many times bond issuers can cover their interest payments with their earnings before interest and taxes (EBIT) and a high ratio implies a high profitability and a low interest burden. Lastly, the cash flow-to-debt ratio indicates how much cash flow bond issuers generate relative to their total debt; a high ratio implies a high liquidity and a low debt service.

3 Market indicators

A third way to assess the creditworthiness of bond issuers is to observe and analyze their market indicators. These signals reflect the market perception and expectation of the credit risk and quality of bond issuers. Credit spread, bond price, and credit default swap (CDS) are some of the most relevant market indicators. Credit spread measures the difference between the yield of a bond and a comparable risk-free bond, such as a treasury bond. A high credit spread implies a high default risk and a low credit quality. Bond price is the amount investors are willing to pay for a bond in the market - a low price may indicate a low creditworthiness and a high default probability. A CDS is a derivative contract that allows investors to hedge or speculate on the credit risk of bond issuers. A high CDS premium implies a high default risk and a low credit quality, which may signal a deterioration in the creditworthiness and a downgrade in the credit rating.