The Federal Reserve approved a fourth consecutive 75-basis point rate hike. The move signaled the most aggressive pace of monetary policy tightening from the US central bank since the early 1980s. 

For investors, the series of continuous rate hikes have caused a huge dent in portfolios as valuations of stocks have plummeted.

One asset which has benefited from the aggressive rate hikes is the bonds. Yields on US bonds have risen to their highest level in over a decade, topping 4%. 

The relative safety of bonds, rising yields, and the stickiness of inflation have made this usually boring asset attractive to investors. However, not all bonds are worthwhile investments for your money. One way investors can filter junk from substance is by looking at the ratings. 

In this article, we take an in-depth look at bond ratings and how investors can use this to choose bonds to invest in.

 

 

What are bond ratings?

Bond ratings perform the same function as credit ratings.

They are scores issued by rating agencies (Moody's, Standard & Poor's, and Fitch) that indicate the creditworthiness of the bonds. 

Creditworthiness in this sense means the issuer's ability to meet the financial obligations of making interest payments and repaying the loan in full at maturity.

Since bonds, like other financial assets, operate on a risk-reward basis, ratings also affect the yield. As such, lower-rated bonds usually offer higher yields to compensate investors for the additional risk. 

Though each rating agency uses its grading system, they all classify bond investments by quality grade and risk. 

Let's have a look at the different bond ratings:

 

Rating 

Description

Investment

Standard & Poor/Fitch

Moody's

AAA

Aaa

Extremely strong capacity to meet financial obligations.

Premium

AA+

Aa1

Very strong capacity to meet financial obligations.

High Grade

AA

Aa2

Very strong capacity to meet financial obligations.

High Grade

AA-

Aa3

Very strong capacity to meet financial obligations.

High Grade

A+

A1

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Upper Medium Grade

A

A2

Strong capacity to meet financial obligations, but somewhat susceptible to adverse economic conditions and changes in circumstances.

Upper Medium Grade

BBB+

Baa1

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Lower Medium Grade

BBB

Baa2

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Lower Medium Grade

BBB-

Baa3

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Lower Medium Grade

BB+

Ba1

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

Non-investment grade speculative

BB

Ba2

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

Non-investment grade speculative

BB-

Ba3

Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

Non-investment grade speculative

B+

B1

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

Highly speculative

B

B2

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

Highly Speculative

B-

B3

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

Highly Speculative

CCC+

Caa1

Highly vulnerable; default has not yet occurred but is expected to be a virtual certainty.

Substantial risk

CCC

Caa2

Highly vulnerable; default has not yet occurred but is expected to be a virtual certainty.

Extremely speculative

CCC-

Caa3

Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

Default imminent

CC

Ca

Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.

Default imminent

C

Ca

Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.

Default imminent

D

C

Payment on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed or similar action taken.

In default

NR

 

The security was not rated.

 

 

What Are Investment-Grade Bonds?

Bonds classified as investment grade have a rating of BBB-/Baa3 or higher.

These bonds are regarded as investment-worthy by the rating agencies, with a manageable level of risk and a low probability of default.

Investment-grade bonds are the ideal choice for investors wishing to place their money in a security that is expected to receive both a stable yield and a return of principal. These bonds may, however, bring lesser yields than trash bonds with higher levels of risk due to their low risk and stability.

 

 

What Are Junk Bonds?

Junk bonds are those with a rating of BB+/Ba1 or lower, commonly referred to as non-investment grade bonds or high-yield bonds. Junk bonds have a higher default risk than investment-grade bonds. They are thought of as speculative investments with a low to high default risk. 

To put it another way, even though bonds are typically seen as less hazardous investments than stocks, these junk bonds could carry more risks than stocks. These higher-risk bonds typically have to pay out higher interest rates as a result, in significant part.

 

 

4 Factors that Affect Bond Ratings

1. The creditworthiness of the issuer

The issuer's credit risk has the most impact on the bond rating.

The capacity of the business to pay back its debts to its creditors is known as credit risk. The bond rating drops if the company's creditworthiness declines. The issuer's balance sheet strength, ongoing business operations, profit margins, and earnings growth are all factors that affect creditworthiness.

 

2. Track record

Credit rating agencies look back at the track record of the issuer. An issuer that demonstrates that its current financial stability is not likely to change shortly usually receives a high credit rating and vice versa.

 

3. Corporate events

Positive or negative corporate events have an impact on a company's bond.

The introduction of a new product is a successful corporate event, whereas a corporate scandal is a negative one. When assigning ratings, credit rating companies take these occurrences into account.

Negative business events receive a poor credit rating, whereas positive corporate events receive a high credit rating.

 

4. The strength of the economy

When a government issues bonds, the strength of its economy is gauged by investors.

This determines the government's ability to meet its debt obligations.

Metrics such as the following are among the factors which investors use to understand the strength of the economy. 

Countries with strong economies usually have lower yields because the risk of default is low. On the other hand, countries with weak economies offer high yields to compensate for risks because the risk of default is higher. 

 

 

Importance of Bond Ratings

Bond rating agencies play an important role in credit laws and regulations in the United States. 

They remain one of the essential sources of information regarding credit analysis and credit risk for investors. Additionally, rating agencies have a big impact on the world financial markets by giving investors an evaluation of assets.

 

 

How to Use Bond Ratings When Investing in Bonds

Bond ratings are used by investors to assist them to choose which bonds are worth their money.

However, most regular investors choose to invest in bond funds that contain a diverse mix of bonds with specific ratings rather than sifting through hundreds of individual bonds.

No matter if you decide to purchase funds or individual bonds, keep in mind that rating agencies only consider a company's present financial status.

Bond rating agencies may not yet have taken into effect the predicted income source's deterioration in their assessments.

Given this, you should keep in mind that bond ratings are simply one of the resources available to investors for assessing bond investments. It shouldn't be the sole metric taken into account when investing in bonds.

Investors should not, however, entirely depend on the credit ratings offered by credit rating companies.

The world financial crisis of 2007–2008 demonstrated the potential for conflicts of interest to arise from the strong ties between credit rating agencies and major financial institutions.

For instance, numerous mortgage-backed securities that were very close to the category of junk securities were given the highest ratings by credit rating organizations.

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Those who want to make stable investments with guaranteed (fixed) incomes are often directed toward bonds.

Bonds are indeed fixed-income investments that can provide a good deal of stability to the investor. But there are several types of bonds, and fixed-income investors should know the differences.

In this article, we will cover:

 

 

What is a Bond?

A bond is a fixed-income debt instrument made by an investor to a borrower.

Bonds are used by companies and government bodies that need to finance their own operations and investments. They are the result of taking corporate or government debt, and securitizing and issuing it as a tradeable asset.

The owner of a bond is a debtholder. The bond investor is essentially lending money, for which they receive the principal plus interest, which creates their profit.

Bonds are invested in with a timetable. The details include the date when the principal is due. Critically, they also lay out the terms for interest payments. Bond repayment interest can be fixed or variable, each with its own pros and cons for the investor.

 

What are the 5 characteristics of bonds?

All prospective bond investments have 5 characteristics worth considering. These are consistent across all types of bonds:

 

 

What are the Types of Bonds You Can Invest in?

There are a few types of bonds you can invest in.

Treasury Bonds

Treasury bonds are government debt obligations. They are backed by the full confidence and credit afforded to the government. They are considered one of the safest, and as such offer low yields relative to other bonds.

Treasury bonds offer the highest credit quality and tax advantages. However, they must be purchased in minimal denominations, making them less accessible to some, unless they are purchased to become a major portion of the buyer’s portfolio.

 

Government Savings Bonds

Savings bonds are also backed by the credit of and faith in the federal government. They are used to finance federal spending. Unlike treasury bonds, they are also highly accessible, requiring a minimum investment that’s only a fraction of that required for treasury bonds.

 

Municipal Bonds

Municipalities issue bonds to raise funds for their projects. These normally include local infrastructure and institutions, such as roads and schools, respectively.

Municipal bonds are seen as fairly safe and benign. The investor is investing in the public good, for which they receive tax breaks on top of the income earned from interest payments.

Municipal bonds are purchased from brokers and often have high minimum investments in the thousands of dollars.

Compared with federal government bonds, municipal bonds are riskier, but offer higher yields.

 

Corporate Bonds

Corporate bonds are one of the broadest categories on this list and come in several sub-categories. But broadly speaking, they share the same characteristics.

Bonds issued by corporations are used to help finance the company’s operations and projects. They can vary widely in terms of:

They work the same way as government bonds, more or less. You, as the investor, loan the company money in return for an IOU that includes regular interest payments.

Compared with all government bonds, corporate bonds are:

Compared to a stockholder in the same company for which you are a bondholder, you are in a safer position. In the case that the company declared bankruptcy and defaults, bondholders are more likely to be at least partially compensated during liquidation.

In terms of diversity, corporate bonds come in differing levels of quality. Investment-grade bonds are issued by companies that are highly rated by credit reporting agencies. Specifically, they’re rated Baa (by Moody's) or BBB (by S&P and Fitch), or higher.

All other bonds that don’t receive those high ratings are non-investment-grade bonds, or “junk bonds”. Junk bonds aren’t necessarily awful, and they produce significantly higher yields. But those higher yields serve as compensation for the higher risk of default that junk bonds carry.

 

Mortgage-backed Securities

Mortgage-backed securities are also referred to as mortgage bonds. They are bonds backed by real estate.

Mortgage bonds are safer than corporate bonds, but not as safe as treasury bonds. In the event of a default, mortgage bondholders can sell off the property backing their bonds to help compensate. But this low level of risk is accompanied by relatively low yields as well.

 

 

What Type of Bonds are Best to Invest in?

This question can be answered according to just two variables:

Overall, bonds are a far less risky investment than most alternatives. However, as an investment, they all carry risk and it is still extremely important to consider your personal risk appetite.

If you want the maximum possible level of safety in bond investments, government bonds are the way to go.

Government bonds come with the strongest chances of reaching maturity without an issue. However, they produce relatively low yields, too. The payoff is that they carry the full credit (and faith) afforded to the federal government.

Corporate bonds are on the other end of the spectrum. This is especially true of junk bonds, which carry a higher risk of default. However, many junk bonds produce yields of around 7%, versus around 3% for federal government bonds. Then, municipal bonds fall somewhere in between.

 

Risk Considerations

 

 

How Do I Start Investing in Bonds?

Most types of bonds can be purchased through brokers. Brokers include banks, bond traders, individual brokers, and brokerage firms. In many cases, there are more direct routes to investing in them.

Savings bonds can be purchased directly through Treasury Direct, the official website of the US Government.

Corporate bonds, however, are normally purchased through one of the types of brokers listed above.

Photo by RODNAE Productions