When investing in bonds, one of the risks you will assume is credit risk, or the chance that the issuer will default on its obligation to you, the investor. One way to assess this risk is to research the issuing entity and examine the credit rating of its bonds. Banks and other lenders use a similar strategy when they check your credit rating before granting you a loan.
There are three primary agencies that evaluate bond issuers and publish ratings. Standard & Poor's Rating Services, Moody's Investors Services, and Fitch ratings, known more commonly as S&P, Moody's, and Fitch. These agencies assign bond ratings based upon several factors that create a broad picture of the fiscal stability of the issuer. These criteria include the nature of the issuer's debt, reliability of cash flow, ability to make interest payments and return principal to investors, and the entity's overall management. The stability of the larger industry or municipality may also be considered.
Bond ratings Bond ratings are subject to change, for better or worse, if the quality of these features change. There is typically an inverse relationship between bond ratings and yield. Bonds with higher ratings, referred to as investment-grade bonds, often pay lower yields than non-investment-grade bonds, which are sometimes called junk bonds. In other words, higher yields are often a way to compensate you for assuming more risk in your investment.
In order to recognize how a particular rating relates to the creditworthiness of a bond issuer, it is important to understand the standardized scales used by each agency. Across all three agencies, a AAA is the highest rating a bond can receive. As you can see, S&P uses a series of capital letters in its ratings, with a plus indicating higher quality for a particular category and a minus indicating lower quality.
Moody's uses a combination of upper and lowercase letters, which are numbered one through three to denote quality. Finally, the system used by Fitch is very similar to the one used by Standard & Poor's. As mentioned before, certain bonds are designated as investment grade bonds.
These are bonds that are rated BBB or BAA and higher. These higher rated bonds are sometimes called bank grade as they are approved by the FDIC for purchase by banks. They are also typically favored by more conservative investors who may be wary of the risk associated with lower rated bonds.
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