Bond ratings: Report cards for risk

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Assigning grades to faith and credit.

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If you’ve ever considered investing in bonds, it’s important to understand bond ratings, also known as credit ratings. These ratings are like report cards created by bond ratings agencies; they’re specifically designed to help investors assess the risks of investing in this asset class.

The biggest risk that bondholders face is default risk, or the likelihood that the bond issuer will be unable to make interest payments or repay the principal when the bond matures. Although default risk can never be eliminated entirely, one of the ways that investors can manage and even minimize this risk is to invest only in bonds with the highest credit ratings.

First, a quick recap of bond market basics. When you purchase a bond, you are in essence loaning money to the entity that issued the security. This is called the principal.

In exchange for the principal, you are entitled to a series of set interest payments. Because the payments do not vary, bonds are considered a fixed-income investment. The payments are called coupon payments.

All bonds have a maturity date, usually one to five years after issuance, at which time the principal is repaid to the purchaser.

There are three main types of bonds:

Generally speaking, sovereign bonds and municipal bonds are considered less risky, while some corporate bonds have such a high risk of default that they’re called junk bonds. High-risk bonds typically offer higher interest rates in order to attract investors.

As with any investment, you should do your homework and understand the risks. But one good thing about bonds is that there are companies—called ratings agencies—devoted to tracking bond issuers and bond risks, and assigning ratings to all sorts of bonds.

Bond ratings can help you evaluate the risk versus reward (that is, the rating versus the yield-to-maturity) on different bonds to determine which ones fit within your risk tolerance and make sense for your investment goals.

There are multiple credit ratings agencies, but only three are considered major players. Although all use similar alphabetic systems, their ratings are based upon proprietary research and analysis.

Standard & Poor’s (S&P). Founded in 1860, S&P is one of the oldest and most widely recognized credit ratings agencies. Its ratings range from AAA (the highest rating) to D (default).

Moody’s. Founded in 1900, Moody’s bond ratings range from Aaa (the highest rating) to C (default).

Fitch. Fitch could be considered the new kid on the block, as it was founded in 1913. Similar to S&P, ratings range from AAA (the highest rating) to D (default).

All three companies use plus and minus signs to indicate whether a rating is closer to the higher or lower end of the rating. In addition, there can be multiple ratings within each letter category.

Bond ratings fall into two general categories: investment grade and speculative grade. Each category contains several letter and sub-letter grades to further pinpoint an issuer’s ability to meet the financial obligations of a bond.

Each ratings agency uses slightly different language to describe each ratings category. Here’s how S&P describes each, according to its Intro to Credit Ratings (see the section “Our Ratings Scale”):

Investment grade

Speculative grade

Bonds that are rated above BBB– (or Baa for Moody’s) are considered “investment grade,” which means they have a lower risk of default. All bonds below those ratings are considered “speculative grade” and carry a higher risk of default.

Treasury bonds usually receive the highest possible credit ratings because they are backed by the “full faith and credit” of the U.S. government. Most municipal bonds (“munis”) are rated investment grade as well because they are issued by local and state governments and backed by their ability to tax and generate revenue.

Corporate bonds (those issued by both private and public companies) are rated based on the company’s debt ratio, profitability, market share, and other fundamental metrics—both current and projected—as well as macroeconomic factors. For this reason, bond ratings agencies review them regularly and will upgrade or downgrade a bond if they feel it’s warranted.

Although bond ratings agencies are not perfect and ratings can change over time, these “grades” provide investors with a simple and straightforward framework to evaluate risk, and more importantly, help minimize the risk of default.

The more you understand about how bonds are rated, the better you’ll be able to decide if—and which—bonds might fit within your investment objectives and risk tolerance.