Bond Credit Ratings: What Investors Should Know

By Author: Ravi
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When you first think about buying bonds one question should come up quickly. Will this issuer really pay interest and principal on time. The answer is never guaranteed but bond credit rating gives you an organised way to judge the risk before you buy bonds for your portfolio.
In simple words a bond credit rating is the opinion of a specialised agency about the ability and willingness of an issuer to meet its debt payments on time. Agencies study the financial statements of the borrower the industry in which it works its track record of repayment and the protections available to investors. They then assign a grade on a scale that runs from the strongest to the weakest category.
At the top of the scale sit ratings that signal very strong capacity to pay. In the middle are ratings that suggest moderate risk. At the lower end are grades that point to high risk of delay or default. Many investors use a broad divide ...
... between so called investment grade on one side and sub investment grade on the other though the exact cut off can vary by market.
It is important to remember that a bond credit rating is an opinion not a promise. An issuer with a strong rating can still get into trouble if business conditions change suddenly. On the other hand a lower rated issuer might improve its finances over time and receive an upgrade. Ratings are reviewed regularly and can move up or down when the facts change.
For individual investors the main use of ratings is as a first filter. When you want to buy bonds you can begin by checking the rating and the date on which it was last reviewed. An older rating that has not been updated for a long time may deserve extra caution. Looking at the outlook positive stable or negative can also give clues about the direction in which risk may be moving.
Ratings also help explain why bonds with similar maturity can offer very different yields. In the bond market issuers that are seen as safer can borrow at lower interest rates. If a bond offers a much higher yield than others with the same tenor it often means the rating is lower and the risk of loss is higher. The extra return is compensation for that risk it is not a free gift.
At the same time investors should not treat ratings as the only truth. Ratings can react with a lag to fast events such as fraud sudden regulatory changes or a collapse in demand. This is why basic homework on the issuer business model cash flows and management quality still matters alongside the rating.
A sensible approach is to combine rating information with diversification and time horizon. For the core of a conservative portfolio many investors stick mainly to high quality government and public sector issuers. Around that they may add a limited amount of lower rated but still reasonably strong corporate names to lift overall yield. Spreading money across issuers sectors and maturities means that a problem in one bond does not damage the full portfolio.
In the end the role of a bond credit rating is to act as a clear indicator on the risk scale not as a guarantee. When you understand how the scale works and respect its limits you can use it as a helpful tool while you invest in bonds that match your need for income and safety.