Credit ratings are the most common benchmark used when assessing corporate bond default risk. These securities are backed by the issuing companies, rather than by government/agency guarantees or insurance. Credit ratings provide an indication of an issuer's ability to make timely interest and principal payments on a bond. Therefore, it is very important to review a corporate bond's credit rating and the effect a rating change would have on the investment. Here, we take an informative look at how corporate bond credit ratings can help determine a bond’s default risk.

An Overview of the Ratings Agencies When considering a potential investment, investors should compare the credit qualities of available corporate bond issues before they invest. The two most recognized rating agencies that assign credit ratings to corporate bond issuers are Moody's Investors Service (“Moody’s”) and Standard & Poor's Corporation (“S&P”). In determining the creditworthiness of an issuer, Moody's and S&P focus on a company's overall financial condition as well as that of the industry in which the issuer operates. A rating represents the opinions of the rating agency at a particular point in time. Ratings on individual issues are continuously revised to reflect any industry or company developments, and these ratings changes can have a distinct effect on an issue's market price. Moody's and S&P classify corporate bond issues as either "investment grade" or "below investment grade”, briefly summarized below: Investment grade bonds (see chart below) are generally more appropriate for conservative clients. These bonds typically provide the highest degree of principal and interest payment protection, and they are generally the least likely to default. Below investment grade bonds (see chart below) may be suitable for more aggressive clients willing to accept greater degrees of credit risk in exchange for significantly higher yields. Investment Grade Moody's S&P Highest Grade: Aaa AAA Moody's These bonds are judged to be of the best quality. They carry the smallest degree of risk. Interest payments are protected by an exceptionally stable margin and principal is secure.     S&P The issuer’s capacity to meet its financial obligation on the bond is extremely strong.     High Grade: Aa1, Aa2, Aa3 AA+, AA, AA- Moody's These bonds are judged to be of high quality by all standards. Margins of protection may not be as large as in Aaa securities.     S&P The issuer’s capacity to meet its financial obligation on the bond is very strong.     Upper Medium Grade: A1, A2, A3 A+, A, A- Moody's These bonds possess many favorable investment attributes. Factors giving security to principal and interest are considered adequate.     S&P Although these bonds are somewhat more susceptible to the adverse effects of changing economic conditions, the issuer’s capacity to meet its financial obligations is strong.     Medium Grade: Baa1, Baa2, Baa3 BBB+, BBB, BBB- Moody's The bonds lack outstanding investment characteristics and have speculative characteristics as well.     S&P Adverse economic conditions are more likely to lead to a weakened capacity of the issuer to meet its financial commitment.     Below Investment Grade Moody's S&P Speculative Grades: Ba1, Ba2, Ba3 BB+, BB, BB- Moody's The future of these bonds cannot be considered as well-assured. B1, B2, B3 B+, B, B- S&P These bonds face exposure to adverse business or economic conditions which could lead to an issuer’s inadequate capacity to meet its financial commitment.     Highly Speculative Grades: Caa1, Caa2, Caa3 CCC+, CCC, CCC- Moody's These bonds are of poor standing. Such issues may be in default, or there may be elements of danger with respect to principal or interest. Ca CC S&P These bonds are vulnerable to nonpayment, and are dependent upon favorable economic conditions for the issuer to meet its financial commitment. C C Default     S&P These bonds are in payment default.   D

An Analysis of Corporate Bond Default Rates An inverse correlation exists between the credit quality and default probability of corporate bonds: the higher the credit rating, the lower the probability of default. Additionally, bonds with greater lengths of time until maturity generally have higher default rates. Furthermore, the lower the credit quality, the greater the chance of default. No matter what the time horizon, lower ratings generally correspond to higher default ratios.

THE BOTTOM LINE: Maturity Correlates with Risk of Default The shorter the length of time until a corporate bond reaches maturity, the less likely the bond will default. Additionally, the higher a corporate bond is rated by the ratings agencies, the lower the chance that it may default. When investing in corporate bonds, a trade-off exists between risk and return. Although lower-rated corporate bonds provide higher yields and capital appreciation potential than their higher-rated counterparts, lower rated corporate bonds have a greater chance of defaulting. A slight upgrade in a bond's credit rating (from "B" to "BB," for example) has, in the past, reflected substantially reduced default risk. The ratings of bonds may change or be withdrawn at any time. The market value of bonds will fluctuate, and investors may receive less than their original purchase price or maturity value. Sales should be made to suitable investors. For more information about credit quality and default rates of corporate bonds, speak to your Morgan Stanley Financial Advisor.