Advanced Search

Types of Bonds

Understanding Credit Risk

Credit ratings

A bond issuer’s ability to pay its debts—that is, make all interest and principal payments in full and on schedule—is a critical concern for investors. Most corporate bonds are evaluated for credit quality by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. (See their rating systems in the chart below.) Checking a bond’s rating before buying is not only smart but also simple: Just ask your financial consultant.

Bonds rated BBB or higher by Standard & Poor’s and Fitch Ratings, and Baa or higher by Moody’s, are widely considered “investment grade.” This means the quality of the securities is high enough for a prudent investor to purchase them.

 
Bond Credit Quality Ratings
Rating agencies
Credit Risk Moody’s      Standard & Poor’s Fitch Ratings 
Investment grade
Highest quality Aaa AAA AAA
High quality (very strong) Aa AA AA
Upper medium grade (strong) A A A
Medium grade Baa BBB BBB
Not investment grade
Lower medium grade (somewhat speculative) Ba BB BB
Low grade (speculative) B B B
Poor quality (may default) Caa CCC CCC
Most speculative Ca CC CC
No interest being paid or bankruptcy petition filed C C C
In default C D D

 

Some bonds are not rated, but this does not necessarily mean they are unsafe. Before buying such a security, however, ask your financial consultant for other evidence of its quality.

High-yield bonds

Bonds with a rating of BB (Standard & Poor’s, Fitch Ratings) or Ba (Moody’s) or below are speculative investments. They are called high-yield, or junk, bonds. Such bonds are issued by newer or start-up companies, companies that have had financial problems, companies in a particularly competitive or volatile market and those featuring aggressive financial and business policies. They pay higher interest rates than investment-grade bonds to compensate for the extra risk. (However, if they were issued before the company’s financial difficulties, the risk may not be offset by a higher yield.)

For those who do not mind taking substantial risk, such securities can provide exceptional returns. For the less adventurous who still want to participate in this market, high-yield bond mutual funds are a way to spread the risk over many issues.

Event risk

In recent years, the managements of many corporations have tried to boost shareholder value by undertaking leveraged buyouts, restructurings, mergers and recapitalizations. Such events can push bond values down, sometimes very suddenly, because they may greatly increase a company’s debt load. Although some corporations have now established bondholder protections, these are neither widespread nor foolproof. All bonds are subject to this potential risk. An individual investor should see if the rating agencies have written commentaries on a company’s vulnerability to event risk before buying the company's bonds.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.