Bond ratings help investors understand the risks involved in buying fixed-income securities. They are issued as letter grades by rating agencies to indicate whether bond issuers are more or less likely to reliably make interest payments and return the principal investment once a bond reaches maturity.
What Are Bond Ratings?
Bond ratings are third-party evaluations of how likely a company or government agency is to pay interest on fixed-income securities and return principal.
“Put simply, bond ratings are a tool that investors use to evaluate the credit quality of a bond quickly,” says Natalie Pine, a Texas-based certified financial planner (CFP). Think of them as companies and local and federal governments’ credit scores.
Bond ratings are assigned by bond rating agencies, like Standard & Poor’s, Moody’s, and Fitch Ratings, based on extensive research and various metrics. Bonds are assigned letters or letter and number combinations corresponding to their creditworthiness. Based on their unique methodologies, these ratings may differ slightly between the bond rating agencies.
“Standard & Poor’s and Fitch use an alphabetical grade, with AAA being the highest rating and D the most likely to default,” says Pine. “From there, a “+/-“ notation can be added to indicate whether the agency believes a move down or up in credit quality is likely.” Moody utilizes a slightly different alphanumerical hierarchy. In general, though, once you go past the first B rating an agency offers, the safety of the bond comes into question.
| Moody’s | S&P | Fitch | |
|---|---|---|---|
| Investment Grade Ratings | Aaa | AAA | AAA |
| Aa1 | AA+ | AA+ | |
| Aa2 | AA | AA | |
| Aa3 | AA- | AA- | |
| A1 | A+ | A+ | |
| A2 | A | A | |
| A3 | A- | A- | |
| Baa1 | BBB+ | BBB+ | |
| Baa2 | BBB | BBB | |
| Baa3 | BBB- | BBB- | |
| Speculative Grade Ratings | Ba1 | BB+ | BB+ |
| Ba2 | BB | BB | |
| Ba3 | BB- | BB- | |
| B1 | B+ | B+ | |
| B2 | B | B | |
| B3 | B- | B- | |
| Caa1 | CCC+ | CCC+ | |
| Caa2 | CCC | CCC | |
| Caa3 | CCC- | CCC- | |
| Ca | CC | CC | |
| — | C | C | |
| — | RD | ||
| C | D | D |
Factors Impacting Bond Ratings
Though the specific evaluation methodologies of each bond rating agency are proprietary, there are general relationships between the ratings and factors like yield, the likelihood of return on investment, and rules governing the securities and company assets.
The highest-rated bonds generally tend to earn a lower yield. That’s because creditworthiness and yield have an inverse relationship: As the likelihood of repayment decreases, companies must offer increasingly higher rates to encourage people to loan them money.
“If you are taking many risks, it makes sense to be appropriately compensated for doing so,” notes Pine.
Additionally, rules about what the company can and cannot do concerning its debts, known as covenants, can also affect the rating of a bond. “Factors like the amount of overall debt a company can take on post bond issuance is an example of a covenant that might affect a bond’s rating,” Pine explains. In that particular case, it might be thought to have a lower risk of default because it can’t overleverage itself or take on dangerous amounts of debt.
Finally, the company’s number of assets can also affect its bond rating. “Whether a bond has insurance backing it or real assets providing back up if the bond is unpaid can also affect the credit quality of a bond,” Pine says. In other words, the more safety net guarantees a bond’s repayment, the higher its score will probably be.
Once these factors have been evaluated and a grade issued, bonds can generally be classified into investment-grade and junk bonds.
What Are Investment-Grade Bonds?
Investment grade bonds receive a rating of BBB-/Baa3 or higher. In the eyes of the rating agencies, these bonds are considered worthy of investment with a reasonable level of risk and a low likelihood of default.
For investors looking to put their money in an investment that is likely to see both a stable yield and a return of principal, investment-grade bonds are the best option. However, these bonds’ low risk and stability may give them lower returns than higher-risk junk bonds.
What Are Junk Bonds?
Junk bonds, also known as non-investment grade or high-yield bonds, are those with a score of BB+/Ba1 or lower.
The default risk on junk bonds is higher than on investment-grade bonds. They are considered speculative investments with a moderate to significant risk of default. In other words, while bonds are usually considered less risky investments than stocks, these junk bonds may hold more significant risks than equities. That’s largely why these higher-risk bonds generally have to pay out higher interest rates.
“Only investors comfortable with greater risk should consider investing in junk bonds,” warns Pine.
How to Use Bond Ratings When Investing in Bonds
Investors use bond ratings to help determine which bonds deserve their investing dollars. Rather than sift through hundreds of individual bonds, though, most average investors choose to direct their money to bond funds that contain a diversified mix of bonds with specific ratings.
You might, for example, buy shares of Vanguard’s Long-Term Investment-Grade Fund or, if you like substantially more risk, Schwab’s Opportunistic Municipal Bond Fund filled with lower-quality bonds.
Rating agencies only look at a company’s current situation regardless of whether you buy individual bonds or funds. If the projected income source is weakening, bond rating agencies may not yet have accounted for that in their evaluations.
That’s why “a bond rating is just one tool that investors can use to evaluate bond investments,” says Pine. “It should not be the only consideration metric for an investment.”