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Rating Bonds

Investors want to know the risks in buying a bond before they take the plunge. Rating services measure those risks.

As a bond investor, you want to be reasonably sure that you'll get your interest payments on time and your principal back at maturity. It's almost impossible for an individual to do the necessary research. But rating services make a business of it.

The best-known of these services are Standard & Poor's, Moody's Investors Service, Inc, and Fitch Inc. These companies investigate the financial condition of a bond issuer rather than the market appeal of its bonds. They look at other debt the issuer has, how fast the company's revenues and profits are growing, the state of the economy, and how well other companies in the same business (or municipal governments in the same general shape) are doing. Their primary concern is to report the risks of a particular issue.

You can find the information from the rating services themselves, the financial press, online bond trading sites, or your broker or financial adviser. As a word of caution, however, remember that ratings are not infallible and risks are sometimes underestimated or missed entirely.

The bond quality rating systems of the two major services are similar, but not identical. Both services also make distinctions within categories Aa/AA and lower. Moody's uses a numerical system (1,2,3) and Standard & Poor's uses a + or –.
Moody's Standard & Poor's Meaning  
Aaa AAA Best quality, with the smallest risk. Issuers exceptionally stable and dependable. INVESTMENT GRADE BONDS
Investment grade generally refers to any bonds rated Baa or higher by Moody's, or BBB or higher by Standard & Poor's.

Aa AA High quality, with slightly higher degree of long-term risk.
A A High-medium quality, with many strong attributes but somewhat vulnerable to changing economic conditions.
Baa BBB Medium quality, currently adequate but perhaps unreliable over long term.
Ba BB Some speculative element, with moderate security but not well safeguarded. SPECULATIVE GRADE BONDS

B B Able to pay now but at risk of default in the future.
Caa CCC Poor quality, clear danger of default.
Ca CC Highly speculative quality, often in default.
C C Lowest-rated, poor prospects of repayment though may still be paying.
--- D In default.

Junk bonds are the lowest-rated bonds. There's a greater-than-average chance that the issuer will fail to repay its debt. Investors may be willing to take that risk because the yields on junk bonds are typically much higher than on more highly rated investments.

The rating services pass judgment on municipal bonds, US corporate bonds, and international bonds. US Treasury bonds are not rated. The assumption is that they pose no risk of default since they're obligations of the federal government, backed by its full faith and credit. This means the government has the authority to raise taxes to pay off its debts. However, Treasury yields and market prices may rise or fall in response to changes in the interest rate and economic conditions.

Credit rating influences the interest rate an issuer must pay to attract investors. In comparing bonds of the same maturity, typically the higher the bond's rating, the lower the interest it pays, and the lower its yield.

Similarly, lower-rated bonds must typically pay higher rates, providing higher yields, to entice investors who might be concerned about whether their interest will be paid on time or their principal repaid. That's why the lowest-rated bonds are sometimes described as high-yield bonds.

One danger bondholders face — and one you can't anticipate — is that a rating service may downgrade its ratings of a company or municipal government during the life of a bond, creating a fallen angel. That happens if the issuer's financial condition deteriorates, or if the rating service feels a business decision might have poor results. If downgrading occurs, investors instantly demand a higher yield for the existing bonds. That means the price of the bond falls in the secondary market. It also means that if the issuer wants to float new bonds, the bonds will have to be offered at a higher interest rate to attract buyers.

When bonds have the same ranking but different terms, those with longer terms typically pay higher rates. This encourages investors to commit their money for an extended period since it helps offset the inflation risk.