When deciding which bonds to invest in, it can be tempting to chase a high yield. After all, that means that you have the chance to earn more money, right? The higher the yield, the more money you get from the bond. Unfortunately, simply relying on a bond yield can be problematic. Instead of making a decision based only on bond yield, look at the ratings as well. Bond ratings can help you determine the likelihood of default.
Who Rates Bonds?
Before you invest in bonds, it’s a good idea to have an idea of what bond ratings mean. The better the rating, the more stable the investment is, and the less likely the issuing organization is to default. Greece offers a great cautionary tale. Bond yields were rising for Greece, and some investors thought they could get a great deal, since prices were low and yields high. However, when Greece went through its restructuring, private bond holders got hit hard, many of them losing out. Greece’s credit rating was awful, and the low rating turned out to be well-deserved.
Companies that rate bonds are supposed to look at the financial condition of the bond issuers, and determine whether or not certain events and situations make the issuer more likely or less likely to default. If the risk of default rises, the bond is downgraded. If things start looking better, bond rating agencies can improve the outlook, and boost the rating.
The two most prominent bond rating agencies are S&P and Moody’s. Both of these agencies offer two “grades” of bonds: Investment and speculative. Bonds that have investment grade ratings are considered fairly safe. Rarely do bonds with investment grade ratings fail, whether they are government bonds or corporate bonds. It happens, but it is a rare event. Speculative grade ratings reflect those that have a higher risk of default. It doesn’t mean that the bond will be defaulted on, but you are on more dangerous ground, and you should be prepared in the event that you lose money on speculative bonds. Here are the ratings:
- S&P Investment Grade Ratings: AAA, AA, A, BBB
- S&P Speculative Grade Ratings: BB, B, CCC, CC, D
- Moody’s Investment Grade Ratings: Aaa, Aa, A, Baa
- Moody’s Speculative Grade Rattings: Ba, B, Caa, Ca, C
Sometimes, you will see addendums to the ratings. With Moody’s, there might be a 1, 2, or 3 applied. This is because bonds are also rated within their groups. So, if a bond is rated Aaa1, it indicates that, among other bonds rated Aaa, that bond is in the top tier. A 2 indicates a mid-range ranking relative to other bonds in the group, and a 3 tells you that the bond might be approaching a downgrade to Aa, since it is at the lower end of the Aaa group. The numerical addition is only added down through Caa ratings.
When looking at ratings from S&P, you might see a + or a – sign associated with an organization’s rating. S&P only applies the + or – to bonds from a AAA to a B rating. The + indicates a higher position in the group, while a – indicates a lower position.
A bond with a lower rating has a higher yield, since investors expect to compensated for taking on the risk. A better rated bond, though, has a lower yield, since the investment its considered safer. If you are looking for safety, you will have to give up yield when you invest in bonds.
Readers: With the financial crisis, do you think the rating agencies have lost their significance?