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Who Rates Bonds?

Bonds are an essential part of any diversified investment portfolio. Depending on an investors age and the level of risk they are willing to assume they may be either more or less heavily invested in bonds. The question is how does an investor determine which bond to buy and whom to trust.

Just as stocks are rated by financial analysts as either buy, sell or hold, bonds are primarily rated by three rating agencies. The three bond rating agencies are Standard and Poors, Moodys and Fitch. These three agencies analyze all available financial information of any bond issuer to determine the risk involved in a given a bond issuance. Based on this analysis, the bond will either be deemed low risk, as in the case of United States Treasuries, or high risk also known as "junk bonds", for companies with shaky finances and at high risk of default.

Before going any further lets first explain what exactly is a bond. This simple definition of a bond is that it is an IOU. It is merely a loan that will hopefully be repaid at the end of the loan term. During the loan term, depending on the level of risk, and interest rate is set and interest payments are made to the bond holder from the bond issuer. As with any other loan, such as personal loans for individuals, the bond issuer's ability to repay the loan determines the level of risk and subsequent interest rate.

Since a bond is nothing other than a loan, many different types of public and private entities issue bonds to pay for such things as capital improvements, corporate expansion, debt recapitalization or any other use as deemed necessary by the bond issuer. Bonds issued by city and local governments are often referred to as municipal bonds and are often free from Federal taxes. Treasury bonds issued by the United States government tend to have low interest rates due to the low risk of bond default. Junk bonds are normally issued by companies on shaky financial ground looking to recapitalize debt or jump-start sales.

As you can see there are a number of different types of bonds applicable to different scenarios and it can be difficult to determine which bonds to purchase. Ratings agencies help facilitate investing in bonds by doing the analyzing and then rating bond issuances. They analyze financial reports, income statements, existing debt and other financial variables to determine the general level of risk of loan default and then apply a simple rating scale to the bond.

Think of the grades you used to get in school with an "A" been really good and a "F" been obviously very bad. The three bond rating agencies use slightly different rating scales that are similar enough to be interchangeable. Generally, ratings start with "AAA" as being the best of the best, "AA" is second best and "AAA" is third best. After that is the tiers of "BBB", "BB" and "B". And finally the bottom tiers of "CCC", "CC" and "C". Bond issuances on the bottom tier are considered "junk bonds" and are very high risk. These bottom tier bonds are so risky that while the interest rate may be incredibly attractive the risk of default is so high that there is no guarantee that the loan will ever be repaid.

The three bond rating agencies analyze financial data of bond issuers on a daily basis. This is due to an ever changing financial situation which could include paying off old loans, increases or decreases in sales and increased labor costs due to renegotiated union contracts. Any variable which could positively or negatively impact the financial health of a company or municipality can lead to a ratings adjustment for outstanding bonds. This ratings adjustment is referred to as either an upgrade or downgrade and can significantly affect both the price and interest rate of the bond in question.

Due to the incredible amount of financial information available and the need to accurately analyze said information to determine the financial health of the bond issuer, the bond ratings agencies are the primary source of what is hopefully the accurate rating of investment grade bonds. There unfortunately is no guarantee and it is always better to use the ratings as part of the bigger picture of analysis when making investment decisions. Talk to your financial adviser, look at all three ratings for a given bond and do any additional research to determine which investment is best for you.