Just like stocks, debt instruments, specifically bonds, can be traded in public exchanges. Since corporate bonds can be a great deal more complicated than stocks, they sometimes come with ratings to help investors understand the potential risks and rewards. Before you buy bonds issued by any entity other than the U.S. government, it is important to grasp what ratings mean and how rated and unrated bonds differ.
Basics of Rating
In finance, the word "rating" refers to a letter grade assigned to a corporation or its debt instruments by a rating agency. These ratings are based on the rating agency's prediction of the default probability. In simpler terms, the better the rating, the more likely the firm will be able to make good on its promise to pay periodic interest and repay the principal. A low rating, on the other hand, indicates a relatively high chance that the firm will fail to honor its payment obligations. Generally, the lower the rating, the higher the interest rate on the bond. This is because a firm with higher risk must offer a juicier return to entice investors.
Agencies and Grades
In the United States, practically all rated bonds are assigned a grade by one of the three major rating agencies: Standard & Poor’s, Fitch and Moody’s. These firms use slightly different scales, but AAA denotes the most stable bonds with the lowest risk, with subsequent letters assigned to higher risk bonds. Grades C and D are assigned to bonds with very high risk and near certain defaults. Bonds with ratings that are below Baa3 or BBB-, depending on the agency, are referred to as speculative grade or junk bonds. The agencies believe that there is a substantial risk of not being able to get your money back when purchasing such a bond.
The rating agencies charge a fee to rate the bonds that must be paid by the issuing corporation. Bonds of smaller firms that cannot pay this fee are unrated and do not carry a grade. In some instances, these kinds of bonds are sold to a firm that is connected to the issuer, such a sister company within the same holding company. In such instances, the buyer may know the issuer inside out and have no need for the independent analysis of the rating firm. The issuer may, therefore, prefer not to pay a rating fee. It is extremely difficult for the independent investor, who is not privy to this information, to assess the risk associated with the bonds, however.
Even when a bond is rated, the intricacies contained in the bond's prospectus -- the official document describing the rights of bondholders -- can be very difficult for the individual investor to grasp. Furthermore, the commissions and fees involved can be prohibitive when buying bonds, and up-to-date price information may not always be available. Therefore, bond funds are usually a better choice for individual investors. Just like stock-oriented mutual funds, a bond fund collects money from a wide variety of individuals and buys a large number of bonds with the proceeds. The expertise of the fund managers and the diversified portfolio of numerous bonds substantially reduces the risk for the individual investor.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.