Bond Ratings Explained

Daniel Penzing
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How Bond Ratings Work

Bonds function as a kind of loan. The government or a company issues bonds, which are essentially IOUs. People buy these IOUs, and in exchange for providing the money that is used to make the bond, they are paid interest. The interest rate that is paid varies from bond to bond depending on the credit rating of the bond issuer.

Bond ratings are issued by a company called Moody’s Investor Services. When a bond is issued with a AAA rating (the highest possible credit rating), it means that the government or company that issued it is likely to pay back the money that it borrowed.

Bond ratings work somewhat like grades at school. When a company issues a bond with a higher rating, it means that it is perceived to be a lower risk. A lower risk means that the bond’s interest payments are also lower. For example, if you invest in a bond that has an AA rating, you will earn more interest than you would by investing in a bond that has a BBB rating.

While a high bond rating is a sign of a low-risk investment, an investment in low-risk bonds will not make you rich. Interest on high-risk bonds will be higher because companies will have to pay these higher rates to convince people to invest money that may not be repaid.

Why Bond Ratings Matter

Companies that issue bonds get a credit rating from the 3 main ratings agencies – Standard & Poor's, Moody¡¦s, and Fitch.

Companies can have bonds of different maturity, risks, and credit ratings.

A bond is a loan that an investor makes to the company who issues the bond.

These bonds are referred to as fixed income investments.

An alternative to stocks, bonds are debt instruments -¡¦ but are generally safer than stocks and will not lose value as easily.

Bonds are¡¦ also safer than loans for the companies since the loans are secured by some sort of collateral, such as property.

One of the most important things about bonds is the interest rate. When you purchase a bond, you will receive interest payments on it for the duration that you own the bond.

The interest rate that you will receive will depend on the credit rating and is outlined in the contract of the loan. The interest payments that you receive are considered taxable income.

Investing in bonds can be tricky. While the interest that you receive is generally low, the risk of losing money is also low. However, this does not mean that investing in bonds or bond funds is always a good idea.

They are somewhat of a safe choice, but there are other things to consider.