Understanding Bond Credit Ratings

Step 1: Why Do I Need to Check the Credit Rating Before Buying a Bond?

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?

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.

On a scale from the best credit quality to the lowest, Table 1 lists the symbols used by each of the major credit rating agencies. These symbols are on the left-hand side. The right-hand side of Table 1 is a translation into plain English of what the ratings mean. Standard & Poor's adds plus (+) and minus (-) signs to its ratings. A plus signifies higher quality; a minus signifies somewhat lower quality. For instance, a rating of B+ is slightly higher than a rating of B. A rating of B- is slightly lower than a B rating. Moody's adds a 1 to indicate slightly higher credit quality; for instance, a rating of A1 is a higher quality credit rating than an A rating.

In order to protect their investments, many individual investors limit their purchases to bonds that are at minimum rated "investment grade," which corresponds to BBB (Standard & Poor's) and Baa (Moody's). The term "investment grade" stems from the fact that fiduciary institutions, such as banks, are permitted by law to invest only in securities rated at the minimum "investment grade." That rating denotes a fair margin of safety. Note that some ads for bond funds use the term "investment grade" to imply extraordinarily high quality, which is misleading.

Table 1. Credit Quality Ratings and What They Mean

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