Understanding Credit Ratings

When you invest in a bond, you're lending money to an issuer.  Your first consideration should be making sure the issuer will pay you back with interest. Credit quality can be a valuable tool in making that assessment because it refers to the ability of the issuer to make interest and principal payments in full and on time.

Credit quality also has an impact on the interest rate of a bond. Issuers with strong credit quality often pay a lower interest rate because their bonds have a low risk of default. Issuers with weaker credit quality typically pay a higher interest rate to compensate for their greater risk.

Comparing Credit Quality
When it comes to credit quality, government bonds are considered the safest bonds available because they are backed by the full faith and credit of a government.

Bonds issued by state-own companies or by government organizations are also considered safe investments. Their credit quality is typically one step below that of government’s bonds.

In contrast, bonds issued by corporations and local governments can vary in quality. The credit quality of these bonds can range from quite high to extremely low, depending on the financial strength of the issuer.

Lower-quality corporate and local government bonds are known as "high-yield" bonds. As the name suggests, these bonds offer very high yields — more than 10% on some corporate bonds — because of the greater risk of default

Using Credit Ratings
Variable credit quality among corporate and local government bonds points to a need for thorough credit research. But it's not easy to assess the creditworthiness of a bond issuer without an in-depth analysis of the issuer's financial situation and the overall financial environment.

Many investors turn to independent credit rating agencies — such as Standard & Poor's (S&P), Moody's, Fitch — that analyze issuers and rate their bonds. These ratings are based on an assessment of a bond issuer's financial strength, and can be an excellent starting point to determine the creditworthiness of a potential bond investment.

Although the following describes the S&P system, all major rating agencies use similar indicators for their credit ratings:

  • AAA is the highest credit rating and D is the lowest.
  • Bonds rated AAA, AA, A and BBB are considered "investment-grade" bonds, which means they are relatively safe from default.
  • Bonds rated BB or below (including B, CCC, CC and C) are considered riskier high-yield investments because they have speculative characteristics and may be vulnerable to default.
  • Bonds rated D are already in default.
  • Ratings may be modified with a plus (+) or a minus (–) to show relative standing within each category.
  • It's important to note that credit ratings represent the opinion of the rating agency; they are not absolute standards of quality. Mutual fund companies often have credit analysts of their own, who do additional research before including a bond in a fund's portfolio.

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