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?
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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.|
|Caa||CCC||CCC||Even more speculative. Substantial risk.|
|Ca||CC||CC||Wildly speculative. May be in default.|
|C||C||C||In default. Junk.|
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