Bond ratings are an essential tool when considering fixed-income investments. Ratings provide a professional assessment of credit risk, or the risk of default, which can be measured to some degree by analyzing the bond issuer's financial condition and creditworthiness.
Credit rating agencies perform this type of analysis and issue ratings that reflect the agency's assessment of the bond issuer's ability to meet the promised interest payments and return the principal upon maturity. The best-known independent rating agencies — Standard & Poor's, Moody's Investors Service, and Fitch Ratings — use similar scales in descending alphabetical order, ranging from AAA/Aaa for the most creditworthy bonds to C/D for the least creditworthy.
Bonds rated BBB/Baa or higher are considered "investment grade." Lower-rated bonds, commonly called "junk bonds," are non-investment grade; they generally offer higher yields and are considered speculative with higher credit risks. Bond insurance can add a layer of protection, but it is only as good as the insurer's credit quality and ability to pay.
A credit rating is not a recommendation to purchase a bond. Even so, higher-rated bonds in general may be more appealing to investors, and — due to supply and demand — typically have a lower yield than similar bonds with a lower rating. Investors must balance risk and reward when choosing bonds that present a comfortable risk while providing a yield that is appropriate to help meet investment goals.
Ratings are very important to a bond issuer when the bond is first offered for sale, because a higher rating may reduce interest costs. After the initial sale, significant shifts in the issuer's financial condition could result in rating changes that may affect the bond's yield and market value. However, as long as the issuer does not default, a change in a bond's rating would not affect the coupon rate or the principal due upon maturity.
Bonds carry other risks as well, such as market risk, interest rate risk, and inflation risk. However, these depend on factors that are difficult to measure or predict.
The principal value of bonds fluctuates with changes in market conditions. A bond sold prior to maturity may be worth more or less than its original value.
What bond ratings do agencies use?
Bond rating agencies typically use similar scales, and it may be helpful to understand how to compare ratings from multiple agencies.
This chart compares bond ratings in descending order of creditworthiness (from left to right) as judged by the three best-known credit agencies.
Standard & Poor's and Fitch Ratings use the symbols + and – to denote the upper and lower ranges of ratings from AA to CCC; Moody's uses the numbers 1, 2, 3 to denote the upper, middle, and lower ranges from Aa to Caa. The bonds in bold are considered non-investment grade.
|Standard & Poor's||AAA||AA||A||BBB||BB||B||CCC||CC/C/D|
|Moody's Investors Service||Aaa||Aa||A||Baa||Ba||B||Caa||Ca/C|
Note: If a bond is insured (typically for lower-rated bonds), there will be two ratings, one for the bond issuer and one for the insurer. Bond insurance adds a potential layer of protection in the event that an issuer defaults, but it is only as good as the insurer's credit quality and ability to pay. An investor should not buy bonds based solely on the insurance.