Bonds are debt securities that investors can purchase and sell in the secondary market. Public institutions such as federal, state and local governments, as well as private companies, can issue bonds for investors to purchase. Just as a bank evaluates an individual or business for its creditworthiness before approving a loan, investors will examine a bond's value before purchasing a debt security. One method by which investors evaluate a bond is by checking its rating.
Debt securities ratings are the collected evaluations on a bond issuer's creditworthiness. The ratings show how experts view the bond issuer's capabilities of repaying the bond. Bonds that receive high ratings are considered low-risk and have a high probability of repayments, while those with low ratings are believed to have a high risk of default. The ratings range from AAA for bonds with a very high probability of repayment, all the way down to D for bonds that have been defaulted.
Bonds are typically rated by three major agencies: Fitch, Moody's and Standard & Poor's. The ratings that these agencies issue don't reflect a recommendation to buy, sell or hold debt securities, nor are they a measure of how likely the issuer is to default on the bond, but the ratings are a reflection of the bond issuer's credit history and are considered "forward-looking statements." Rating agencies can also change their ratings on a bond if outside economic factors affect the company's ability to repay the debt.
Ratings agencies can charge substantial fees to evaluate and rate bonds. Some bond issuers, including small businesses seeking to raise capital, may choose not to have their bonds rated. Investors who are considering the purchase of unrated debt must take their own measures to determine the default probability on the bond, such as a careful evaluation of the issuer's financial health and credit history. However, some highly reputable companies, including Heineken and Credit Suisse, have bypassed the ratings process in issuing their corporate bonds.
A bond portfolio is a collection of bonds grouped together to accomplish an investor's goals. These goals can range from an aggressive, high-risk/high-reward strategy to a steady stream of interest income. Since bond ratings are an evaluation of past performance, rather than a predictor of future returns, a bond portfolio can include both rated and unrated bonds geared toward accomplishing the portfolio's mission. Also, a bond portfolio can decline in value regardless of whether the bonds in it are rated or not.
- The Motley Fool: Rated Debt vs. Unrated Debt
- Standard & Poor’s Financial Services LLC: Credit Ratings Definitions & FAQs
- Moody’s: Understanding Moody’s Corporate Bond Ratings And Rating Process
- Wall Street Journal: Credit Ratings Now Optional, Firms Find
- Financial Industry Regulatory Authority, Inc.: Smart Bond Investing—Bond Funds
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