Bond Basics: How Ratings Work

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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.

However, in order to get the most accurate understanding of the risk surrounding your investment, van Doorn advises consumers to also “consider the issuer” behind the bond. For example, if you’re looking to buy bonds in a public school, it’s important to do due diligence to make sure that school appears financially solvent. This is something you can try to do on your own with a little research, but ultimately, you’ll probably need to rely on a broker to get this information for you.

Even if you notice a company does have a bad bond rating, that doesn’t always mean you should refrain from investing in it. Typically, those companies with poor bond ratings will offer you higher yields as an incentive to invest in them. So you’ll be guaranteed more money in interest early on, though of course you still run the risk of losing some of your original investment by the time the bond comes due.

It’s also important to note that obviously the bond rating may change over the time that you hold the bond, and thereby affect the market value of your investment. But according to van Doorn, that change won’t affect you unless you decide to sell your bonds before they reach maturity.

Ultimately, van Doorn stresses the fact that bonds are not for everyone. “If you are not interested in long-term investment that produces income, then you should not invest in bonds,” he said.

For more reading, check out van Doorn’s watch list of troubled banks and his piece on the new subprime market. Also, be sure to look at MainStreet’s coverage of which bond investments are appropriate for different age groups. And if there’s anything you want us to address about bonds in the future, feel free to leave your questions in the comments section.

—For a comprehensive credit report, visit the BankingMyWay.com Credit Center.

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