Fixed Income: Bond Ratings

Bond Ratings

The quality of any bond is based on the issuer's financial ability to make interest payments and repay the loan in full at maturity. Rating services help to evaluate the creditworthiness of bonds. Some bonds, such as municipal bonds, may be insured by third parties.

How Bond Ratings Work?

Two of the major independent credit rating services are Moody's and Standard & Poor's. They research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. A bond's rating helps you assess that bond's credit quality compared to other bonds.

Fine Points on Reading the Ratings

Moody's and Standard & Poor's append their ratings with an indicator to show a bond's ranking within a category.


•		Moody's uses a numerical indicator. For example, A1 is better than A2 (but still not as good as Aa).

•		Standard & Poor's use a plus or minus indicator. For example, A+ is better than A, and A is better than A-.

Ratings and Yield

Ratings affect a bond's yield, or the percentage return investors can expect on the bond.


•		A highly rated bond typically has a lower yield. That's because the issuer does not have to offer as high a coupon rate to attract investors.

•		A lower rated bond typically has a higher yield. That's because investors need extra incentive to compensate for the higher risk.

Company 1 and Company 2 both offer similar bonds. But Company 1 has received a better Moody's rating, so it can sell its bonds at a lower coupon rate.

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Investment Grade and High Yield Bond

Investors typically group bond ratings into two major categories:


•		Investment grade refers to bonds rated Baa/BBB or better.

•		High Yield (also called speculative risk) refers to bonds rated below Baa/BBB. You need to have a high risk tolerance to invest in these bonds.

Downgrades and Upgrades

Because the financial health of an issuer can change - including municipalities and corporations alike - the rating services can downgrade or upgrade a company's rating.

It is important to monitor a bond's rating regularly. If a bond is sold before it reaches maturity, any downgrades or upgrades in the bond's rating as well as other market factors will affect the price others are willing to pay for it.

U.S. Treasury Bonds and Insured Bonds

U.S. treasury bonds are not rated. Assuming they are held to maturity they are considered extremely credit worthy, because they are backed by the federal government, which in the event of a default will guarantee the repayment of the principal. Agency (or Government Sponsored Enterprises) bonds are also not normally rated. GSE bonds are not explicitly backed by the full faith and credit of the U.S. Government but they have implied government backing and an implied Aaa/AAA rating.

also provide protection. Assuming the financial health of the insurer, an insurer has guaranteed the payment of principal and interest upon maturity.

Of course, because there is less risk of default, the interest rate for these securities is low compared to other bonds.

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Test Yourself

You are nearing retirement and want to minimize the credit risk on a bond you are purchasing. What rating may you look for in a bond? What may you need to sacrifice?
See the answer.

You own a corporate bond and the issuing company reports a large operating loss for its fiscal quarter. What concern should you have related to the bond's rating?
See the answer.


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