Bond Ratings Understanding the Basics
Bond Ratings Understanding the Basics
Understanding Bond Ratings: A Comprehensive Guide
Bonds are an essential tool for diversifying and managing risks within an investment portfolio. However, navigating the world of bonds can be complicated, especially with the different ratings assigned to them. In this article, we will delve into the basics of bond ratings and how they can help you make informed investment decisions.
The Relationship Between Risk and Yield
When it comes to buying bonds, it’s common for investors to be attracted to the ones with the highest yields. But it’s crucial to consider the quality of the bond itself in addition to its yield. High yield may not always compensate for the risk associated with the bond issuer’s ability to make timely payments. For most small investors, it is advisable to stick with high-quality bonds.
At the top of the safety scale are U.S. government bonds. As the sole borrower in the market allowed to print money to repay its debts, the U.S. government bonds offer the highest level of security.
Securities issued by U.S. agencies, corporations, and local governmental units offer varying returns and risk profiles. Here, you can find bonds ranging from those almost as solid as U.S. government issues to those close to or already in default.
So how do you find high-quality bonds? Reliable and respected ratings agencies exist that gather and analyze data to assign ratings to bonds. These ratings are widely used by financial professionals and have a significant impact on the bond’s price and yield.
- SEC targets technologies promoting excessive trading.
- U.S. Agency Bonds Bond Basics
- 9 Ways to Teach Kids Good Money Habits at Any Age
The Ratings Agencies
The major players in the bond ratings landscape are Moody’s Investors Service, Standard & Poor’s Corp (S&P), and Fitch. These agencies assign ratings based on an issuer’s creditworthiness and the likelihood of default.
S&P Investment Grade Ratings:
- AAA
- AA
- A
- BBB
- BB
- B
Moody’s Investment Grade Ratings:
- Aaa
- Aa
- A
- Baa
S&P Speculative Grade Ratings:
- BB
- B
- CCC
- CC
- D
Moody’s Speculative Grade Ratings:
- Ba
- B
- Caa
- Ca
- C
S&P’s ratings of AA, A, BBB, BB, and B can be supplemented with a plus (+) or a minus (-) sign to indicate a bond’s position within the respective rating group. Moody’s, on the other hand, uses numerical modifiers (1, 2, 3) to indicate a bond’s ranking within its generic rating classification.
Investment-grade bonds are those typically sought by individuals and institutional investors looking for a steady income stream and safety. BBB/Baa is the lowest rating that qualifies for commercial bank investments. Bonds with this rating have a higher likelihood of adverse economic conditions or changing circumstances affecting their capacity to pay interest and repay principal.
When bonds fall below BBB/Baa, they enter speculative territory. These bonds carry a higher risk of default and therefore offer higher yields, often referred to as “high yield” or junk bonds.
While Moody’s and S&P generally align in their ratings, discrepancies can occur, with one agency rating an issue one grade apart from the other. This disparity implies uncertainty regarding the issuer’s creditworthiness.
How Ratings Affect Price
As you move up the quality scale, you can expect to pay a higher price for a bond and receive a lower yield. For example, a triple-A bond usually costs more than a double-A bond with similar characteristics. Investment-grade bonds rarely default, making the highest ratings especially attractive.
The ratings agencies actively monitor the financial condition of bond issuers and update their ratings as necessary. Many bonds are upgraded or downgraded each year, so it’s essential to check the current ratings before purchasing bonds that have been on the market for some time.
The Bottom Line
Bonds are often considered a safe investment alternative, allowing investors to earn interest and cash in their investment at maturity. This holds true for investment-grade bonds. However, not all bonds receive the coveted investment-grade rating. Ratings agencies perform thorough analyses and grade bonds according to their level of risk, including the likelihood of default. Utilizing their ratings as a guidepost can help you make informed decisions and avoid taking on more risk than you can bear for the promise of high returns that may not materialize.
Related Content
- Bond Basics: U.S. Savings Bonds
- Municipal Bonds Stand Firm
- Bond Basics: U.S. Agency Bonds
- Why Treasury Bills Are a Good Bet
