Bonds are not the easiest investments to figure out. A bond fund, apart from its description, doesnt tell you much about all the risks involved either. In an environment where investors chase higher yields, the greater risk of loss can be quickly ignored. Bond ratings make it easy for you to understand the default risk of a bond. while still taking into account all the other risks.

What Are Bond Ratings?

Bond ratings are credit scores for governments and companies. It measures the issuers financial strength and ability to make interest and principle payments to bondholders. For investors, these grades are an easy way to do a credit check without digging into financial statements.

The ratings are easy enough to understand. The higher the bond rating, the lower the risk of default. For that, the company gets a lower cost to borrow. For you, its a lower interest rate on the bond, but a higher chance youre paid in full.

A bonds rating will change as the issuers credit score changes. When investors view the change as good, it will increase demand and raise the price of the bond, lowering the interest rate. Of course, the opposite could happen or nothing could happen. It depends on whether investors see the change as positive or negative.

In order to understand investor sentiment, you need to know the bond ratings scale, which is made up of a combination of letter grades. If you understand the letter grades in school, this should be easy.

Bond Ratings Scale

The three main ratings agencies are Standard & Poors. Moodys and Fitch. There isnt a standard ratings system between each agencies. Standard & Poors and Fitch use a similar ratings scale. Moodys complicated things in their effort to differentiate themselves. So you have three ratings agencies with different scales. Each one based on the agencys unique grading criteria.

The highest ratings (AAA to BBB-) are considered investment grade bonds. These are Treasuries and high quality municipal, corporate, and foreign bonds.

Anything lower (BB+ and lower) are non-investment grade, consisting of high yield or junk bonds. With the higher yields brings more risk. The risk default rises with each lower grade. Heres an easy way to remember it: As are good, Bs are average risk, and Cs or lower are very risky.