Rating agencies assign ratings to bonds based on the level of risk the agencies associate with those investments. Ratings might not always reflect risk entirely accurately, and a rating can change after the bond has been issued on the markets. Nonetheless, ratings are designed to provide a glimpse into the creditworthiness of bond issuers, and to offer investors some expectations for risks and returns.
In the United States, the three major bond rating agencies are Moody's, Standard & Poor's and Fitch. Although each firm uses its own formula and system for rating bonds, their goals are similar. Ratings are assigned so that investors are aware of the creditworthiness of an issuer and know they will be compensated fairly relative to the amount of risk. Interest rates on bond securities are set partially in response to the level of risk associated with the investment based on ratings.
Investment-grade bonds are considered somewhat safe because these issuers are the least likely to default. A default occurs when a bond issuer misses scheduled interest payments to investors. Subsequently, investment-grade debt securities receive the highest grades by ratings agencies. There are different levels of investment grade, and the higher the quality of the bond, the better the rating. Investment-grade bonds issued by corporations tend to deliver higher returns than government-issued bonds, but that are more modest than high-risk debt securities, according to CNN Money.
High-yield bonds, sometimes called junk bonds, are the most risky debt securities. Although returns on these high-yielding investments are more attractive than the returns on investment-grade bond yields, junk bonds receive the lowest grades by credit rating agencies. The financial health of high-yield bond issuers is typically questionable, and subsequently these investments pose the greatest risk for default. If an investment-grade bond can become at risk for a downgrade to junk status, rating agencies typically issue some warning first.
Credit ratings agencies were blamed for not properly grading subprime mortgage investments when financial market turmoil began in 2007, according to an article that year in "Forbes" titled "Credit Crisis Hurts Rating Agencies." Despite signs of trouble, rating agencies did not lower the ratings on risky mortgage bonds until it was too late, according to the article. And investors did not perform proper research on bond investments before the crisis, basin investment decisions too heavily on credit ratings.
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