Understanding Bond Credit Ratings—And What They Have to Do With Your Investments

You know that you have a credit score, but did you realize that bonds do, as well? Bond ratings are grades (determined by bond rating agencies) that can give you insight into a bond issuer’s financial strength and capacity to repay its debts.

If you’re a fixed-income investor or you have bonds as part of your portfolio mix, read up about bond ratings and what they mean for your investments.

What are the bond rating agencies and what do they do?

The bond ratings agencies are private companies that work a little bit like consumer credit rating agencies or credit bureaus. They research the financial health of bond-issuing institutions (including financial institutions, corporations, governments and municipalities) to assess creditworthiness and assign bond ratings based on their evaluations.

The agencies’ purpose is to help investors understand the risks of investing in bonds, and to have a basis for understanding the quality and stability of certain bonds. Bond ratings are also influential in determining interest rates, investment appetite, and bond pricing, so these agencies look at future expectations when assigning ratings.

The three most widely known agencies are Standard and Poor’s Global Ratings, Moody’s Investors Service, and Fitch Ratings. These agencies are responsible for issuing 95% of ratings.

What are the different bond ratings and what do they mean?

Bond ratings range from the highest, AAA, to the lowest, C and D. The highest rated bonds — those rated AAA, AA, and A — are considered low risk when it comes to investing. These are known as investment-grade bonds and are typically issued by corporations or government entities.

The next level on the rating scale is Baa or BBB, and while also considered investment grade, the bonds with these ratings carry a moderately higher risk for investors.

Those bonds that are assigned a lower B, C or D rating are considered non-investment grade or speculative, and as such are deemed to carry the highest risk (more on that below).

Here’s a look at the proprietary ratings each agency uses and how they correlate to one another, ranging from strongest to weakest.

What does “non-investment grade” or “speculative” mean?

Non-investment grade bonds, speculative bonds, high yield bonds and junk bonds are all different names for the same thing. Bond issuers that are struggling financially and have a higher risk of default are issued credit quality ratings below BBB-.

The term “high yield” signals that these bonds offer the prospect of higher returns in the form of higher interest payments to entice investors. However, issuers of high yield bonds are less likely to pay investors on time (which is partly where the higher payments come in), and even if they produce higher returns than investment-grade bonds, they do produce historically lower returns than stocks over the long term. Investors who seek out high-yield or junk bonds must be aware of the risks and have a high risk tolerance.

How should you consider bond ratings in your investment planning?

Although ratings can be useful in determining which bonds you should buy, it is recommended that you don’t make investing decisions based on ratings alone. Ratings are just one piece of the puzzle and, as anything having to do with money and investing, aren’t a perfect indicator of whether your investment will increase or decrease in value.

As always, we believe that working with your wealth advisor can help you determine the best investments for you.

Don’t try to make sense of all your investment options alone. Let the wealth advisors at Ironwood Wealth Management help. Get started today.