Bond Basics: How Ratings Work

Bonds may be a great purchase for the savvy investor, but for the average consumer, the world of bonds can be confusing, and potentially risky if you’re not clear on all the terms. What’s the difference between a bond fund and a municipal bond? Should you invest in tax-exempt bonds? And how can you tell if your broker is trying to fleece you? MainStreet hopes to answer each of these questions and more in the coming weeks, but today, we will take a look at one of the essential aspects of bonds - ratings.

First things first, let’s nail down the basics. When you invest in a company’s bonds, you are essentially providing that business with a loan. In return, the company will ideally pay you back that original sum plus a generous interest rate that often trumps what your bank would offer you on a CD or savings account. That interest rate gets paid out to you in regular installments, also known as the yield. That all sounds like a pretty sweet deal, until you factor in the risk that the company you’re investing in may not be stable enough to pay back your original investment when it comes due. This is where bond ratings come in.

A bond rating represents the likelihood that the institution you are investing in will default on your original loan. Consumers should view this rating as a kind of advertisement for the financial health of the business and the risk that you can expect with the bond. These ratings are determined by independent rating agencies like Moody’s and Standard & Poor’s and the ratings apply to everything from businesses and public organizations to state governments.

So what exactly is considered a good bond rating?

“Anything BBB or higher is considered investment grade, and anything below that is considered a junk bond,” said Philip van Doorn, the Senior Banking Analyst at TheStreet, our sister site. Bond ratings can go as high as AAA, which means there is very minimal risk with the investment, and as low as C for Moody’s and D for the S&P, both of which mean the business is either in default already or about to be.