Bond ratings are the best way to measure the amount of risk you are taking on when you invest in bonds. Bond ratings give investors an idea of how well a company is managing their debt, and if they are expected to meet their obligations.
Ratings are very simple to understand, and they can help you measure risk and returns for your bond funds. Mutual fund managers scrutinize these ratings to find the best invesment opportunities, and you can do the same thing with bond funds to maximize your returns.
Investing in a bond is like loaning your money to a specific company, the government, or individual borrowers. When banks evaluate a person for a loan, they look at that person’s credit rating. Companies and governments have credit ratings just like you and I, and these ratings affect how they can borrow money.
The Two Types of Credit Ratings
There are only two types of credit when investing in bonds: good credit and bad credit. Here are the explanations for each one:
- Investment-grade bonds have a favorable credit rating, which means the company is expected to meet its obligations. The bond market considers these bonds to have a good credit rating.
- Below investment-grade bonds have a lower credit rating. Investors may refer to these as junk bonds, and fund companies refer to these as high-yield bonds (because high-yield sounds better!). These bonds generally have more risk than investment-grade bonds.
High-yield bonds are not automatically a bad investment, but they do carry more risk. Some investors prefer higher interest rates and are willing to accept those risks. Even though a company has a lot of debt or high interest rates, they may not have a problem paying back their bonds.
It helps to understand what these terms mean, but you should refer to the credit ratings chart to more accurately measure risk.
How To Understand Credit Ratings
Credit rating agencies assign credit ratings to each bond a company issues. These ratings are simple to understand and will help you measure bond risks more accurately for a mutual fund. This can help you avoid losing money and decide if you are earning a good return for your fund’s risks.
For mortgage-backed and other asset-backed bonds, bond ratings measure how well the borrowers are expected to meet their obligations. For example, if you invest in mortgage-backed bonds, you want to know if the people making the mortgage payments are expected to make their payments.
Credit Ratings Chart
The three major ratings agencies are Standard & Poor’s, Moody’s, and Fitch. This colorful chart will help you understand what each company’s ratings mean.
| What bond ratings mean | Moody’s | Standard & Poors | Fitch |
| Highest credit quality; issuer has a strong ability to meet its obligations. | Aaa | AAA | AAA |
| Very high credit quality; low risk of default. |
Aa1 Aa2 Aa3 |
AA+ AA AA- | AA |
| High credit quality, but more vulnerable to changes in the business or economy. |
A1 A2 A3 |
A+ A A- | A |
| Adequate credit quality for now, but more likely to be impaired if conditions worsen. |
Baa1 Baa2 Baa3 |
BBB+ BBB BBB- | BBB |
| Below investment grade, but a good chance that issuer can meet commitments. |
Ba1 Ba2 Ba3 |
BB+ BB BB- | BB |
| Significant credit risk, but issuer is presently able to meet obligations. |
B1 B2 B3 |
B+ B B- | B |
| High default risk. |
Caa1 Caa2 Caa3 |
CCC+ CCC CCC- |
CCC CC C |
| Issuer failed to meet scheduled interest or principal payments. | C | D |
DDD DD D |
Why Bond Ratings Matter
Bond ratings are not set in stone, they can be changed at any time. Ratings agencies can either downgrade or upgrade credit ratings if a company’s credit gets worse or improves. You should always consider the possiblity that a bond issuer’s credit may get worse.
Bond credit ratings are not an exact science, and they don’t always tell the whole story. Here is a good example of how bond ratings can mislead investors:
In 2007, the U.S. housing market collapse caused the value of mortgage bonds to fall, which triggered problems in the financial system and the economy. This started a vicious cycle where credit ratings changed rapidly, investors panicked, and companies had to mark down the value of their bonds. This cycle repeated until eventually people stopped borrowing and lending to each other in 2008 and the credit market froze.
Most bond investors are not aware that the companies trying to sell their bonds pay the ratings agencies fees to rate their credit. Ratings agencies have an incentive to provide good ratings to the companies paying them. This can create a conflict of interest, so you should evaluate bond ratings with a bit of skepticism and your common sense.
Of course, bond ratings also have an ethical responsbility to investors and an incentive to rate credit accurately. If investors lose confidence in a rating agency, bond issuers will stop paying them to rate their debt.
Credit ratings are not perfect, but they are a good guideline to help you measure risk. Make sure to always ask yourself whether the person you are loaning your money to will be able to pay you back. If you are unsure of the answer, you are taking a serious risk.
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