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Want to invest in bonds? You'll need to understand how their credit ratings work…

by , 23 November 2015

There are three main credit ratings agencies which hold a lot of clout with their ratings. These are Moody's, Standard & Poor's and Fitch.

As well as providing other ratings, these agencies give ratings for bonds.

So how do these bond credit ratings work?

Let's take a closer look…


The main categories of bond credit ratings

 
There are two main categories that bonds fall into:
 
  1. Investment grade; and
  2. Sub-investment grade.
 
Investment grade
These bonds have a rating of BBB- or higher. With Moody’s, this is Baa3.
 
Sub-investment grade
These bonds are also known as junk, high yield or speculative grade bonds. They have ratings of BB+ or lower. With Moody’s this is Ba1.
 
These bonds tend to have higher yields as they’re riskier for investors. By offering a higher interest rate, the borrower can lure investors to buy its bonds.
 

How these bond credit ratings work

 
When investing in bonds, investors will look at credit ratings. Bonds with investment grade status should be able to comfortably meet their debt obligations.
 
On the other hand, those with sub-investment grade status are riskier and there is a higher chance of default as you go down the scale.
 
For instance, Moody’s believes that between 1983 and 2010, investment grade bonds had a one year default rate of 0.09%. This is much lower than the default rate of 4.75% for junk bonds.
 
You need to be aware of the higher risks that come from the fine line between investment grade and sub-investment grade bonds. But by taking on this extra risk, you should see higher returns from these bonds.
 
So there you have it. How the credit ratings of bonds work.
 
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Want to invest in bonds? You'll need to understand how their credit ratings work…
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