Bond ratings explained Via ForbesAdvisor
Though the specific evaluation methodologies of each bond rating agency is proprietary, there are general relationships between the ratings and factors like yield, the likelihood of return on investment, rules governing the securities and company assets.
The highest rated bonds generally tend to earn a lower yield. That’s because creditworthiness and yield have an inverse relationship: As likelihood of repayment decreases, companies must offer increasingly higher rates to encourage people to loan them money. “If you are taking a lot of risk, it makes sense to be appropriately compensated for doing so,” notes Pine. Additionally, rules about what the company can and cannot do with respect to its debts, known as covenants, can also affect the rating of a bond. “Factors like the amount of overall debt a company can take on post bond issuance is an example of a covenant that might affect a bond’s rating,” Pine explains. In that particular case, it might be thought to have a lower risk of default because it can’t overleverage itself or take on dangerous amounts of debts. Finally, the amount of assets the company has can also affect its bond rating. “Whether a bond has insurance backing it or real assets providing back up if the bond is unpaid can also affect the credit quality of a bond,” Pine says. In other words, the more safety net to guarantee repayment that a bond has, the higher its score will probably be. Once these factors have been evaluated and a grade issued, bonds can generally be classified into investment-grade bonds and junk bonds.Investment grade bonds receive a rating of BBB-/Baa3 or higher. In the eyes of the ratings agencies, these bonds are considered to be worthy of investment with a reasonable level of risk and low likelihood of default. For investors looking to put their money in an investment that is likely to see both a stable yield and a return of principal, investment-grade bonds are the best option. However, the low risk and stability of these bonds may give them lower returns than higher-risk junk bonds.Junk bonds, also known as non-investment grade bonds or high-yield bonds, are those with a score of BB+/Ba1 or lower. The default risk on junk bonds is higher than those of investment grade bonds. They are viewed as speculative investments, with a moderate to significant risk of default. In other words, while bonds are usually thought of as less risky investments than stocks, these junk bonds may hold greater risks than equities. That’s in large part why these higher-risk bonds generally have to pay out higher interest rates. “Only those investors who are comfortable with taking greater risk should consider investing in junk bonds,” warns Pine.Investors use bond ratings to help determine which bonds deserve their investing dollars. Rather than sift through hundreds of individual bonds, though, most average investors choose to direct their money to bond funds that contain a diversified mix of bonds with certain ratings. You might, for example, buy shares of Vanguard’s Long-Term Investment-Grade Fund or, if you like substantially more risk, Schwab’s Opportunistic Municipal Bond Fund filled with lower-quality bonds. Regardless of whether you choose to buy individual bonds or funds, though, remember that rating agencies are only looking at the current situation of a company. If the projected income source is getting weaker, bond rating agencies may not yet have accounted for that in their evaluations. That’s why “a bond rating is just one tool that investors can use to evaluate bond investments,” says Pine. “It should not be the only metric of consideration for an investment.”
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