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Understanding Bond Ratings

A bond rating is a grade applied to a bond issuance clearly specifying the quality and level of risk assumed by a bond purchaser. Bond ratings are determined by the three bond rating agencies Standard and Poor's, Moody's and Fitch.

There is no difference between a corporation or government issuing a bond to improve roads or to build a school and an individual seeking a personal loan to buy a car or house. In either situation, the entity seeking the loan is counting on other individuals to fund the loan on agreeable terms. The goal of those funding the loan is to be repaid the principal plus additional interest which makes the loan worthwhile.

When applying for a personal loan, the terms used to describe and individuals ability to repay a loan amount is often called creditworthiness or credit risk. What is the likelihood that the person seeking the loan has the ability to repay the loan, a history of successfully repaying loans and the financial resources to make monthly payments? Financial institutions take these factors into consideration when determining whether or not to issue an automobile loan or a mortgage.

Bond rating agencies perform a similar function when evaluating bonds. Rating agencies determine a corporation's or government's ability to repay the initial principle of a loan in addition to the interest payments. When a local government issues a bond to build a new school that cost $100,000,000 that municipality needs to be able to repay the 100,000,000 plus any additional interest. Rating agencies look into the municipality's financial solvency including sales tax, property tax and investment revenue as well as other financial information and then rates the school bond issuance.

Needless to say, it can require a tremendous amount of financial information and not all of it may be readily available to the average investor. Rating agencies are highly specialized in analyzing all appropriate financial data in light of current macro economic conditions and assess risk accordingly. The end result of all this analysis is the bond rating which guides and investor's investment decisions.

All three bond rating agencies rate bonds when they are first issued and then continually analyze additional financial information and adjust ratings in light of changing economic status. While more often than not the three rating agencies bond ratings coincide sometimes they do not agree completely. While one agency may rate a given municipal bond as AAA the other two agencies may rate the same bond AA. Fortunately this is usually the exception than the rule because if it weren't it could leave to investor confusion.

Standard & Poor's: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, D

Moody's: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C

Fitch: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC, DDD, DD, D

As illustrated above, bond ratings are very easy to understand and are comparable to grades one would receive in school. Letter "A" grades are the best and "B", "C" and "D" grades are progressively worse. AAA rating bonds are of the highest quality which makes them some of the safest bond investments but they also have some of the lowest interest rates. C and D level bonds, which are also known as "junk bonds", are some of the riskiest bonds an investor can own but also have some of the highest yields and best potential returns.

Assuming the bond rating agencies grading of a bond issuance is accurate then it should be very easy to determine based on risk aversion which type of bond and investor would buy. But as we all know it is never safe to assume and an investor should always take additional steps and conduct more research to make sure a bond purchase is appropriate for their financial goals. Hopefully this information helps investors determine the types of bonds they would like to own when diversifying their investment portfolio.