Bond Rating - What Do I Need To Know About Rating Bonds ?

Summary: Research on bonds fills volumes. Or these days, the hard drives of web servers. Nowhere else in the investing world can the interested investor get more helpful information than that available from the various bond rating agencies.

Related Articles: What Is A Bond, municipal bond funds, tax bonds

Bond Rating Agency

S & P bond ratings (Standard & Poor's) and Moody bond rating are the most well known, but there are many others. (DBRS in Canada and Fitch are only two examples.) These bond rating agencies provide investors with thoroughly researched ratings on the risks associated with buying a particular company's (or government's) bond.

Stocks frequently get recommendations - (strong) buy, hold, sell - from analysts. Bond ratings get assigned over 20 different possible designations, from AAA (Highest Grade) to C (May Be In Default) or worse. And those designations are backed by some of the most thorough historical and technical research on the planet. The local geology of most cities is less well understood than the financial condition of many companies.

Because of select fixed characteristics - unlike stocks, for example, bonds always have an associated interest rate (which is sometimes zero) and a set maturity date - bonds are more predictable. Those two factors alone makes possible the use of an array of mathematical tools to provide predictions of future yields and price with a confidence unmatched by any other investment.

Standard and Poor's ratings comprise of around 2,000 domestic and foreign companies, 8,000 government entities, and 1,300 commercial paper-issuing entities. Moody's ratings rates over 19,000 long-term debt issues, 28,000 municipals, and 2,000 commercial paper issuers.

Some of the more common and useful ratings are explained below.

Moody's  S&P's
Aaa      (AAA)

Bonds rated Aaa are judged to be of the best quality, carrying the smallest degree of investment risk. Interest payments are typically protected by a large or exceptionally stable margin and the principal is believed secure.

Baa     (BBB)

Baa rated bonds are considered medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security are thought adequate at the time the rating is made, but might prove unreliable over time. Such bonds are less secure and have some speculative characteristics too.

B      (B)

Bonds with B rating are generally considered speculative. Interest and principal payments are not assured.

Corporate bond rating

A Moody rating may have digits following the letters, for example, A2 or Aa3, indicating finer grading. S&P attaches plus signs to some for the same purpose.

Agencies make clear that bond credit ratings don't represent recommendations one way or the other, but taking them into account is common practice. But remember, bond ratings for a particular issue can change over time, as the issuer's fortunes wax or wane.

In general, bonds with higher ratings tend to have lower yields. Higher risk bonds offer higher yields and/or lower prices in order to attract investors. These so-called high yield or 'junk bonds' (below Baa/BBB) aren't necessarily bad investments.

In 1991, those who gambled on lower rated bonds reaped the highest total returns: an average 34.5 percent. One year later, in a less outstanding year for bonds, junk debt took second place in the race for high returns, 18.2 percent compared to 22.4 percent return on convertible debt. The example remains relevant today.

Even at the lower figure, they outpaced many stocks. Of course, that's an average and when considering a purchase investors have to look not only at potential returns but expected default rates.

Statistics making that estimate more rational are available from dozens of Internet sites that report on bonds. The prudent investor will take advantage of that information when making an investment decision.