Understanding Bond Credit Ratings

Step 7: Wouldn't Buying 30-Year Bonds With AAA Ratings and Just Holding Them to Maturity Be the Safest Thing to Do?

Not necessarily. That can be a costly and high-risk strategy. It is costly because AAA-rated bonds yield less than bonds with lower ratings but with similar maturities. You are therefore sacrificing income. And it is high-risk for two reasons: One is that, as we have just seen, interest rate risk is far higher for bonds with longer maturities. If you need to resell your bonds before they mature, you might have to take a very costly hit to principal. But in addition, it is very difficult to predict how much you will really earn on bonds with the longest maturities because that will largely be determined by varying reinvestment rates earned on interest income.

As a general rule, if you are concerned about safety of principal and predictable income, it is usually safer to buy bonds with maturities of five to 10 years, rated at least investment grade or higher (depending on your preferences and tolerance for risk). Interest income from such bonds is likely to be close to (and occasionally higher) than that of AAA-rated bonds with long maturities, so you will not be sacrificing income. But risk to principal is dramatically lower, because short-term bonds are less volatile than long-term bonds when interest rates change.

A Ratings Summary

Here is a summary of what you will want to remember concerning ratings:

• When you purchase bonds, you should check credit ratings by the major agencies. Most of the time, ratings issued by the different rating agencies are close. If they are not, then to be safe, assume the lowest rating is accurate.
• Buy bonds rated investment grade (or higher), depending on your risk tolerance. A rating of A or better represents a sound rating, particularly for bonds with maturities under five years.
• Be sure that you understand the main reasons for the rating. What sources of revenue will pay debt? What is the credit history of the issuer? Has it been upgraded or downgraded? Why?
• When you own a bond, monitor its rating. Ask your broker to let you know if any rating changes occur (and check periodically). If a significant downgrade occurs, and you feel uncomfortable holding, you may want to consider selling that security. Note that occasionally the price of some bonds drops in advance of a rating change. The market is sometimes ahead of the rating agencies in sniffing out that a particular security may face potential problems.
• Diversify. Don't put all your assets in one bond. If you have a total of $50,000 to invest, it is more prudent to buy five $10,000 lots than one $50,000 lot. Buy bonds of different issuers to diversify credit risk. And buy bonds with different maturities to diversify interest rate risk.