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Learn what a bond rating is and how to use it to choose the best bonds for your portfolio.
What is a bond rating?
A bond rating, also known as a credit rating, is an assessment of the creditworthiness of a bond issuer. These ratings are provided by independent credit rating agencies and serve as a measure of the issuer's ability to meet its financial obligations, particularly the payment of interest and the repayment of the principal amount when the bond matures.
Bond ratings are typically expressed as letter grades or alphanumeric symbols, with each rating agency having its own scale. For example, a higher-quality bond is less risky and might receive a rating of AAA, AA or A. Lower-quality bonds are riskier and might receive a rating of BB, B, CCC or lower.
How different bond rating agencies assess credit ratings
Credit rating agencies use their own methodologies and criteria to assess bonds. The three major credit rating agencies—Standard & Poor's (S&P), Moody's Investors Service and Fitch Ratings—follow a structured process to determine credit ratings.
S&P and Fitch use a scale that starts with AAA for the highest quality and goes down to D for "default." Moody's uses a similar scale starting with Aaa and going down to C, but it incorporates alphanumeric ratings, such as Aa1, Ba1 and Ca1. These numeric modifiers indicate the ranking quality within each category. For example, two bonds rated Aa2 and Aa3 both fall within the same category, but the one rated Aa3 is considered a lower grade.
A bond may also be described as "not rated" for various reasons: insufficient credit history, extremely low credit quality, issuance through a private placement, or issuance from a smaller company or municipality that's not seeking a credit rating.
What a bond rating measures & how it's determined
Here's a general overview of how credit agencies measure and assess ratings:
- Financial analysis. Agencies may analyze income statements, balance sheets and cash flow statements.
- Industry and economic analysis. They assess the issuer's industry, including its growth prospects, competitive dynamics and broader economic factors (such as interest rates, inflation and economic stability).
- Credit history. They consider the issuer's credit history and track record of meeting debt obligations as well as any past defaults or credit events.
- Regulatory and political environment. Credit agencies review the regulatory environment in the issuer's home country, including compliance with regulations. Foreign issuers are subject to further assessment of the political and economic stability of their home country.
It's important to note that credit rating agencies are separate entities, and their ratings may not align perfectly. Investors should consider ratings from multiple agencies and do their own due diligence in researching when assessing credit risk.
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How do investors use these bond credit ratings?
Bond ratings provide investors with a quick and standardized way to evaluate the credit risk of a bond issuer. Higher-rated bonds are generally considered lower risk while lower-rated bonds are viewed as higher risk. Investors can use these ratings to assess the likelihood of the issuer meeting its debt obligations. For example, a ratings downgrade may prompt investors to reassess their holdings and take appropriate actions to manage risk.
Investors may also use credit ratings to align their investment horizon and liquidity requirements with bonds of the appropriate risk level. This can help determine when to buy or
Investment-grade vs. junk bonds
Investment-grade bonds and junk bonds (also known as high-yield bonds) are two categories of bonds that differ primarily in terms of credit quality, risk and potential returns. Here's a brief comparison of these two types of bonds:
- Investment-grade bonds. These are bonds that have a low risk of default and are typically issued by governments and large, well-established companies. Investment-grade bonds offer lower yields than junk bonds, but they are also less risky. Ratings are typically BBB-/Baa3 and higher.
- Junk bonds. These bonds have a higher risk of default and are typically issued by companies with weaker financial positions. Junk bonds offer higher yields than investment-grade bonds, but they carry more risk. Ratings are typically BB+/Ba1 and lower.
Making bond ratings work for you
Bond ratings help investors make informed decisions about the level of risk they are willing to take when investing in bonds. However, it's important to note that credit ratings are just one piece of the puzzle when making investment decisions.
Conducting thorough research, regularly monitoring investments and partnering with an