Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Bond Rating

What it is:

A bond rating is a "grade" assigned to a bond. These ratings also can be assigned to bond issuers, insurance companies or other entities or securities to indicate riskiness.

How it works (Example):

Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading bonds based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.

  • For S&P, the ratings vary from AAA (the most secure) to D, which means the issuer is in default.
  • For Moody's, the ratings go from Aaa to C, which means the issuer is likely already in default.

Only bonds with a rating of BBB or better are considered 'investment grade'. BBB bonds are considered to be suitable for investment by institutions. Anything below the triple-B rating is considered to be junk, or below investment grade. Bond ratings are periodically revised based on recent data.

Treasury Bonds are not rated because they are backed by the "full faith and credit" of the United States government. They are considered to be the safest of investments because of the fact that the government has the power to levy taxes in order to pay its debts.

Why it Matters:

Bond ratings have huge influence on the price and demand for certain bonds. The lower the rating, the riskier the investment and the less the investment is worth. Low bond ratings often lead to less trading activity and thus liquidity problems. This is why downgrades (or rumors of downgrades) in an issuer's credit rating can have a significant impact on its bonds and on the market or industry.

Low bond ratings are not always bad. They simply mean there is more risk associated with a bond and thus more potential for higher returns. In fact, many income investors actively enhance their returns by dividing bonds into sectors based on certain characteristics such as credit rating, yield, coupon, maturity, etc. and then finding those sectors that will perform most favorably for the investor under certain market conditions.