Bonds help add diversity to your portfolio, control risk and help you decide whether or not to make an investment. Bond ratings are indications of the likelihood of repayment in accordance with the terms of the issuance. But the competing rating systems can make it more complicated to understand what the ratings mean. We can help you understand the agencies different bond ratings and how to use them to evaluate the inherent risk a particular bond carries.
The relationship between risk and yield
When buying bonds, it's tempting to look for the highest available yields. But yield figures can be misleading. You also need to take into account the quality of the bond itself. If there's any doubt about the ability of the bond issuer to pay on time, high yield could be poor compensation for the risk. In general, small investors should stick with high-quality bonds.
At the top of the safety scale are U.S. government bonds. The government, after all, is the only borrower on the market that can print money to pay its debts, if necessary.
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Securities issued by U.S. agencies, corporations and local governmental units have a higher risk profile. There you will find bonds ranging in quality from those that are nearly as solid as U.S. government issues to those close to or already in default.
How do you find high quality bonds? There are reliable and respected ratings agencies that gather all the data and issue ratings. These ratings are used by financial professionals across the board and greatly impact the price and yield of a bond.
What are the main bond ratings agencies?
Most widely-traded bonds are rated by at least one of the major agencies in the field — Moody's Investors Service and Standard & Poor's Corp. Fitch also rates bond issues for default risk.
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
Standard and Poor's AA, A, BBB, BB, and B ratings are sometimes supplemented with a plus (+) or a minus (-) sign to raise or lower a bond's position within the group.
Moody's applies numerical modifiers in each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its rating; a 2 indicates a midrange rank; and a 3 indicates a ranking in the lower end of the generic rating category.
The investment grades include bonds ordinarily bought by individuals and institutional investors seeking a steady stream of income and safety. BBB/Baa are the lowest ratings that qualify for commercial bank investments. It's a borderline group for which, in Standard & Poor's words, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for bonds in higher-rated categories.
Dipping below BBB/Baa takes you into speculative territory. Because of their higher risk of default, such bonds must pay higher yields. "High yield" is the marketing name for what most people call junk bonds.
Moody's and Standard & Poor's don't always agree on a bond's rank. It's not unusual for them to rate an issue one grade apart. If you see this happening, take it as a sign of uncertainty about the company that issued the bond.
How bond ratings affect price
Normally you pay a higher price, and receive a lower yield, with each notch you move up the quality scale. A triple-A bond usually costs more than a double-A with comparable characteristics, a double-A costs more than an A, and so on. Few investment-grade issues have ever defaulted. But the few instances of default are enough to reinforce the attractiveness of the highest ratings.
The rating agencies try to track the financial condition of issuers and update their ratings if necessary. In fact, many issues are either upgraded or downgraded each year, so check current ratings when buying bonds that have been on the market for some time.
Bottom line
Bonds are often considered a safe way to park money, collect interest and cash in at maturity. That is true of investment grade bonds, but not all bonds get that coveted rating. Ratings agencies do a thorough analysis and grade bonds according to their risk, including likelihood of default. Use their ratings as a guidepost and don't take on more risk that you can bear for the promise of a large return that may never materialize.
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