investing

Bond Basics: What the Ratings Mean

Knowing the creditworthiness of your bond issuer can help limit the risk of default.

Bonds help add diversity to your portfolio and control risk. But they can be complicated. We can help you understand the basics and make bonds work for you.

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 Agencies

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.

Most Popular

Are You Rich? The Answer May Surprise You
personal finance

Are You Rich? The Answer May Surprise You

Whether you are considered rich depends on how you measure it – and the bar for that is changing. Have a look at the numbers that define who's wealthy…
August 12, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Save More on Green Home Improvements Under the Inflation Reduction Act
Tax Breaks

Save More on Green Home Improvements Under the Inflation Reduction Act

Tax credits for energy-efficient home improvements are extended and expanded by the Inflation Reduction Act.
August 19, 2022

Recommended

What’s All the Fuss About Direct Indexing?
investing

What’s All the Fuss About Direct Indexing?

Investors who want control over which stocks they own are looking at direct investing. It comes with some distinct advantages, but it’s not for everyo…
August 19, 2022
10 Best Bond ETFs to Buy Now
ETFs

10 Best Bond ETFs to Buy Now

The bond market has struggled in 2022, but investors with a longer-term view should consider these bond ETFs to balance their portfolios.
August 18, 2022
The Strong Dollar’s Winners and Losers
Foreign Stocks & Emerging Markets

The Strong Dollar’s Winners and Losers

The greenback’s rise may hurt companies with a global footprint, but benefit those that depend on imports.
August 17, 2022
The Berkshire Hathaway Portfolio: All 45 Warren Buffett Stocks Ranked
stocks

The Berkshire Hathaway Portfolio: All 45 Warren Buffett Stocks Ranked

The Berkshire Hathaway portfolio is a diverse set of blue chips, and increasingly, lesser-known growth bets. Here's a look at every stock picked by Wa…
August 16, 2022