When buying bonds, it's tempting to look for the highest available yields. But yield figures can be misleading unless you also take into account the quality of the bond itself. If there's any doubt about the ability of the bond issuer to pay off on time, high yield could be poor compensation for the risk. In general, small investors should stick with high-quality bonds. But what is high quality? And how high is high enough?
At the top of the safety scale are U.S. government bonds. The government, after all, is the only borrower on the market that can print money to pay its debts, if necessary.
Below that lofty level lies a vast array of securities issued by U.S. agencies, corporations and local governmental units. There you will find bonds ranging in quality from those that are nearly as solid as U.S. government issues to those close to or already in default.
The ratings. Most widely traded bonds are rated by at least one of the major agencies in the field -- Moody's Investors Service and Standard & Poor's Corp. Fitch also rates bond issues for default risk.
S&P Investment Grade Ratings: AAA, AA, A, BBB, BB, B
Moody's Investment Grade Ratings: Aaa, Aa, A, Baa
S&P Speculative Grade Ratings: BB, B, CCC, CC, D
Moody's Speculative Grade Ratings: Ba, B, Caa, Ca, C
Standard and Poor's AA, A, BBB, BB, and B ratings are sometimes supplemented with a plus (+) or a minus (-) sign to raise or lower a bond's position within the group. Moody's applies numerical modifiers in each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its rating; a 2 indicates a midrange rank; and a 3 indicates a ranking in the lower end of the generic rating category.
The investment grades include bonds ordinarily bought by individuals and institutional investors seeking stable income and safety. BBB/Baa is the lowest rating that qualifies for commercial bank investments. It's a borderline group for which, in Standard & Poor's words, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for bonds in higher-rated categories.
Dipping below BBB/Baa takes you into speculative territory. Because of their higher risk of default, such bonds must pay higher yields. "High yield" is the marketing name for what most people call junk bonds.
Moody's and Standard & Poor's don't always agree on a bond's rank. It's not unusual for them to rate an issue one grade apart. If you see this happening, take it as a sign of uncertainty about the company that issued the bond.
How ratings affect price. Normally you pay a higher price (and thus receive a lower yield) with each notch you move up the quality scale. A triple-A usually costs more than a double-A with comparable characteristics, a double-A costs more than an A, and so on. Few investment-grade issues (those above junk ratings) have ever defaulted. But there have been enough cases to reinforce the attractiveness of the highest ratings.
The rating agencies try to track the financial condition of issuers and update their ratings if necessary. In fact, many issues are either upgraded or downgraded each year, so you must check current ratings when buying bonds that have been on the market for some time.