What’s the Deal With Bond Ratings?
Most investors know that risk is an important factor in any investment decision. Prudent investors seek to maximize returns at an acceptable level of risk.
Investors buying corporate and municipal bonds routinely use bond ratings to estimate risk. Neither infallible nor permanent, these objective evaluations appraise the current financial stability of bond issuers. They are prepared by independent rating agencies and can serve as a guide for investors and their financial advisors.
The principal rating agencies are Moody’s Investors Service and Standard & Poor’s (S&P). After their analysts assess a number of factors, they assign a letter rating to each bond. Under the Moody’s system, investment-grade bonds — issues that may be suitable for purchase by conservative investors — are rated Aaa, Aa, A and Baa. S&P rates these groups as AAA, AA, A and BBB.
Conveniently, the two rating agencies’ systems are comparable (at least for the A and B categories). So, for example, a bond rated Aaa by Moody’s is comparable to one rated AAA (“triple A”) by S&P. Bonds carrying these ratings are judged to be of the highest quality, with the least risk that the issuer will fail to make all interest and principal payments on time. As a result, issuers of these bonds can generally offer the lowest interest rates.
The lowest rating for a bond on Moody’s scale is C, a warning to investors that the issuer’s chances of meeting its obligations may be poor. Likewise, S&P’s bottom rating is D, which indicates that the issue is in default, with one or more payments in arrears.
Both systems have modifiers within each category. These modifiers are 1, 2 and 3 for Moody’s, and plus and minus signs in the case of S&P. For example, a Moody’s rating of A1 is better than A, but lower than Aa; a Moody’s A3 is equivalent to an A- from S&P.
What is the overall effect of bond ratings? In general, the lower the risk, the lower the return. An investor looking for safety will settle for less return than an investor who can tolerate more risk and wants the higher yields offered by lower‑rated bonds. Such an investor might buy a few issues in the mildly speculative Ba/BB category, although he or she should be aware of the credit risk involved. Naturally, individuals should consult with their financial advisors before making this kind of decision.
Because rating changes can affect the value of one’s investment portfolio, investors should check the ratings periodically. In addition to The Wall Street Journal, the financial pages of many daily newspapers regularly publish changes in bond ratings. A bond’s current rating can also be found in either Mergent (formerly Moody’s) Bond Record or S&P’s Bond Guide.
If you hold a bond whose rating has been downgraded, you should discuss the situation immediately with your financial advisor to see whether you should hold the bond, or sell it to reinvest the proceeds in a higher‑quality issue.
Provided by courtesy of Aaron Jousan Johnson, Managing Director with JCAP Group in Darien, CT.
Our firm does not render legal, accounting or federal or state tax advice. Please consult your CPA or attorney on such matters.
The accuracy and completeness of this material are not guaranteed. The opinions expressed are those of the author(s) and are not necessarily those of JCAP Group, J. Capital, or its affiliates. The material is distributed solely for informational purposes with no fee and is not a solicitation of an offer to buy any security or instrument or to participate in any trading strategy.
