How Credit Ratings Affect Bond Valuations

There is widespread misunderstanding about what credit ratings really mean, and how they affect the returns that you earn and the overall riskiness of your portfolio.

Investors generally rely on bond ratings to evaluate the credit quality of specific bonds. Credit ratings indicate on a scale of high to low the probability of default; that is, the probability that debt will not be repaid on time in full. Failure to redeem principal at maturity would constitute a default. Failure to make interest payments on time (that is, to pay coupons to bondholders) would also constitute a default. In plain English, ratings answer two questions: How likely am I to get my money back at maturity, and how likely am I to get my interest payments on time?

Share this article

All bonds are not subject to default risk. Any security issued directly by the U.S. government is considered free of default risk. Although these bonds are not rated, they are considered the safest and highest-quality securities that you can buy because a default by the U.S. government is deemed impossible. This includes all Treasury securities, as well as savings bonds.

Bonds issued by entities other than the U.S. government, such as corporate bonds and municipal bonds, are rated by a number of agencies that specialize in evaluating credit quality. The best-known rating agencies are Moody's, Standard & Poor's (S&P), and Fitch (now Fitch IBCA). Bonds are rated when issuers initially come to market, and subsequently, as issuers bring additional issues to market. Issuers pay the agencies for the rating.

Table 1. Credit Quality Ratings and What They Mean
Moody's	Standard & Poor's	Fitch IBCA
Aaa	AAA	AAA	Gilt edged. If everything that can go wrong does go wrong, they can still service debt.
Aa	AA	AA	Very high quality by all standards.
A	A	A	Investment grade; good quality.
Baa	BBB	BBB	Lowest investment-grade rating; satisfactory, but needs to be monitored.
Ba	BB	BB	Somewhat speculative; low grade.
B	B	B	Very speculative.
Caa	CCC	CCC	Even more speculative. Substantial risk.
Ca	CC	CC	Wildly speculative. May be in default.
C	C	C	In default. Junk.

To read more, please become an AAII Registered User or CLICK HERE.

Discussion

No comments have been added yet. Add your thoughts to the discussion!

November 2001 Issue

Bonds
Why Bond Prices Go Up and Down
Since the late 1970s, changes in the interest rate environment have become the greatest single determinant of bond returns, and managing interest rate risk has become the most critical variable in the management of bond portfolios.

Bonds
How Credit Ratings Affect Bond Valuations
Since the late 1970s, changes in the interest rate environment have become the greatest single determinant of bond returns, and managing interest rate risk has become the most critical variable in the management of bond portfolios.

Bonds
You CAN Lose With Bonds
Many investors put money in bonds to receive interest income and assume their original investment - their principal - will not change in value. However, this assumption is wrong! What you can do to protect your money.

Stocks
What Steps You Should Take When Your Stock's Price Falls
There are no simple rules that will tell you when to sell a stock, but an in-depth understanding of what economic, industry, and firm fundamentals drive the price will better equip you for making decisions.

Features
Bond Investing Basics: Why Bond Prices Go Up and Down
Bonds: Since the late 1970s, changes in the interest rate environment have become the greatest single determinant of bond returns, and managing interest rate risk has become the most critical variable in the management of bond portfolios.

Features
How to Benefit From Reduced Capital Gains Rates
Tax Strategies: The Tax Relief Act of 1997 established lower capital gains tax rates for assets held for more than five years and sold sometime after 2000. Special election rules also allow individual to reset a stock's acquisition date to Jan. 2, 2001.

Features
When Markets Turn Bad the Basics Remain Fundamental
Feature: The year 2001 has been an example of the need for diversification across styles as well as industries. And the entire bear market should emphasize the need for a long-term commitment.

Features
U.S. Government Bond Funds: A Portfolio Counterweight
Mutual Funds: As a relatively low risk, understandable and steady counterweight for your stock portfolio, U.S. government bond funds are hard to beat if you do not want to buy the bonds directly and manage them yourself.

Features
What Steps You Should Take When Your Stock's Price Falls
Stock Selection Strategies: There are no simple rules that will tell you when to sell a stock, but an in-depth understanding of what economic, industry, and firm fundamentals drive the price will better equip you for making decisions.

Features
An Interview With Matthew B. Fahey, Portfolio Manager, Marshall Mid-Cap Value Fund
Feature: A bottom-up value approach looks for mid-cap stocks that can make the grade.

Features
Variable Life Insurance Policies and Stock Market Volatility
Insurance Products: The life insurance industry has treated variable life as just a better-performing version of whole life and universal life without realizing that inherent investment volatility makes variable life a very different kind of life insurance.

Departments
AAII Journal 2001 Index of Articles
An index of all articles appearing in the AAII Journal during 2001.

Stock Strategies
What Steps You Should Take When Your Stock's Price Falls
There are no simple rules that will tell you when to sell a stock, but an in-depth understanding of what economic, industry, and firm fundamentals drive the price will better equip you for making decisions.

How Credit Ratings Affect Bond Valuations

Share this article

Discussion

In This Issue

November 2001 Issue