Investment grade generally refers to any bonds rated Baa or higher by Moody's, or BBB or higher by Standard & Poor's.
Junk bonds are the lowest-rated bonds. There's a greater-than-average chance that the issuer will fail to repay its debt. Investors may be willing to take that risk because the yields on junk bonds are typically much higher than on more highly rated investments.

As a bond investor, you want to be reasonably sure that you'll get your interest payments on time and your principal back at maturity. It's almost impossible for an individual to do the necessary research. But rating services make a business of it.

The best-known services are Standard & Poor's, Moody's Investors Service, Inc, and Fitch Inc. These companies investigate the financial condition of a bond issuer rather than the market appeal of its bonds. They look at other debt the issuer has, how fast the company's revenues and profits are growing, the state of the economy, and how well other companies in the same business (or municipal governments in the same general shape) are doing. Their primary concern is to alert investors to the risks of a particular issue.

Issuers may not publicize their ratings unless they are top of the line. So you may need to get the information from the rating services themselves, the financial press, online bond trading sites, or your broker or financial adviser.

RATING A BOND: A KEY TO THE CODE
The bond quality rating systems of the two major services are similar, but not identical. Both services also make distinctions within categories Aa/AA and lower. Moody's uses a numerical system (1,2,3) and Standard & Poor's uses a + or – .
Moody's
  		Standard & Poor's Meaning
 
Aaa AAA Best quality, with the smallest risk. Issuers exceptionally stable and dependable AAA

INVESTMENT
GRADE
BONDS
Aa AA High quality, with slightly higher degree of long-term risk
A A High-medium quality, with many strong attributes but somewhat vulnerable to changing economic conditions
Baa BBB Medium quality, currently adequate but perhaps unreliable over long term
Ba BB Some speculative element, with moderate security but not well safeguarded  
B B Able to pay now but at risk of
default in the future
Caa CCC Poor quality, clear danger of default JUNK BONDS

Ca, CC Bonds
Ca CC Highly speculative quality, often in default
C C Lowest-rated, poor prospects of repayment though may still be paying
— D In default


WHICH BONDS GET RATED?
The rating services pass judgment on municipal bonds, US corporate bonds, and international bonds. US Treasury bonds are not rated. The assumption is that they pose no risk of default since they're obligations of the federal government, backed by its full faith and credit. This means the government has the authority to raise taxes to pay off its debts. However, Treasury yields may rise or fall in response to changes in the interest rate and market conditions.

RANKING INFLUENCES RATE
Credit rating influences the interest rate an issuer must pay to attract investors. In comparing bonds of the same maturity, typically the higher the bond's rating, the lower the interest it pays, and the lower its yield.

Similarly, lower-rated bonds must typically pay higher rates, providing higher yields, to entice investors who might be concerned about whether their interest will be paid on time or their principal repaid. That's why the lowest-rated bonds are sometimes described as high-yield bonds.

THE RISK OF DOWNGRADING
One danger bondholders face — and one you can't anticipate — is that a rating service may downgrade its ratings of a company or municipal government during the life of a bond, creating a fallen angel. That happens if the issuer's financial condition deteriorates, or if the rating service feels a business decision might have poor results. If downgrading occurs, investors instantly demand a higher yield for the existing bonds. That means the price of the bond falls in the secondary market. It also means that if the issuer wants to float new bonds, the bonds will have to be offered at a higher interest rate to attract buyers.

Yield Comparisons TIME IS MONEY
When bonds have the same ranking but different terms, those with longer terms typically pay higher rates. This encourages investors to commit their money for an extended period since it helps offset the inflation risk.

 

Return to top of page

 

© 2006 by Lightbulb Press, Inc.
All Rights Reserved.
Disclaimer