Credit Rating Basics for Bonds - All Bonds Are Not Equal in Risk

If you have ever looked into buying bonds as an investment then you have no doubt seen the credit ratings that are associated with them. These ratings are given out by a number of credit rating agencies such as Fitch, S&P, and Moody's among others, but they all typically assign a series of letters such as AAA to let potential investors know the quality of the bonds in question.

When I was a broker I had clients confused by this all the time. They would simply look at the yield of a bond and of course want to go with the higher yields. The general thinking is that all bonds are considered to be "safe" investments, but what I have had to point out on more than one occasion is the fact that all bonds are not so safe.

For the most part you can think of credit ratings as a grade you would receive in school. The A letters are the best and then the B, C, and D letters are worse off. Take for example the credit rating style of S&P and what they mean:

AAA... This is the best rating and usually means that the bond is in no danger of defaulting on payments.

AA+

AA

AA-...These are high grade and still considered to be a safe with very little chance of default.

A+

A

A-...These are considered safe unless something in the economy or particular sector which the bond is in happens.

BBB+

BBB

BBB-...These are considered a medium-safe investment and usually a product of economic turbulence.

BB+

BB

BB-...This is where bonds become speculative or what is referred to as "Junk Bonds." The future is usually cloudy and not easy to determine whether or not a default will happen going forward.

B+

B

B-...These Junk Bonds are ones with deteriorating situations ongoing and a likelihood of defaults is expected.

CCC

CC

C...These bonds carry a large risk and the underlying company likely faces bankruptcy or some other type of business interruption. Defaults are highly expected.

D...Riskiest of the risky and default is usually imminent.

Typically the higher the rating is on the bond the lower the yield will be. For this reason, some brokers will refer to Junk Bonds as "high yield bonds" most likely because that name is easier to digest then one with the word junk in it.

Determining what type of bonds are good for your portfolio all depends on the amount of risk you are willing to take. Before you decide on a bond or bonds for your investment purposes you should sit down and discuss the pros and cons thoroughly with your financial advisor.

Source: Bond Pickers, Bond Ratings Explained, BondPickers.com