2.2.  Bond Ratings

Before a bond is issued, it is rated according to its credit risk. The more creditworthy an issuer is, the less likely it is to default on its debt payments. Rating agencies, such as Standard & Poor’s, Moody’s Investors Services, and Fitch Ratings, are hired by the issuing company to assess its financial strength. An agency’s evaluation of a company’s ability to pay a bond’s principal and interest in a timely fashion will determine the bond’s coupon rate. The higher the rating agency’s grade, the lower the perceived risk, and thus, the lower the coupon rate on the bonds.

The S&P and Fitch bond ratings are expressed as letters ranging from AAA to D. A “triple-A” rating is the most desirable, representing an “investment-grade” bond with the least credit risk. The rankings go down by grade (AAA to AA) and by notch (AA+ to AA). Many mutual funds and investment advisors only invest in bonds that are considered to be investment grade. To be considered investment grade, a corporate bond must be rated at least BBB- by S&P and Fitch, or Baa3 by Moody’s. Bonds below investment grade may be called high-yield, speculative, or junk bonds.

Each of the rating services uses the same basic grading system, with some variations in style. Here is a summary: