Investment Tips: Who Rates Bonds?

There are thousands of bonds available to the investor, and it can be difficult to decide which ones are the safest for your money. Find out who rates these bonds, and how they decide on their grades.

Many investment experts believe that bonds are a good way to diversify and lower the risk of a portfolio, but the world of bonds can be full of hidden minefields. In order to help navigate this potentially treacherous terrain, investors look to ratings agencies to help determine which bonds are best for them.

Before exploring what bond ratings are who is responsible for coming up with them, it is important to understand exactly what a bond is. A bond is quite simply an IOU - you, as the investor, are lending money to a bond-issuing entity, who in return promises to pay you interest on the loan over a period of time. When that period of time is up, they will repay you the original amount that you lent them (or the face value). Essentially, the bond issuers are paying you for the right to use your money over the length of the bond term.

There are many different types of bonds available, depending on who the issuer is. Some of these include U.S government bonds, state and municipal bonds, and corporate bonds. This means that if you buy a U.S. government bond, you are lending money to the federal government with the assumption that they will be able to repay you on time. The price of the bond and the interest rate will depend on who you buy the bond from - buying from the U.S treasury is considered virtually guaranteed, for example, so the interest rate that you will receive on your investment will not necessarily be as high as if you buy a bond from a corporation or a local government, which may run into financial difficulty and default on the loan.

Because there are so many different entities that issue bonds, it can be difficult to know which organizations will be able to best repay their debts. Without spending countless hours on researching the financial situation of various corporations or municipal governments, buying bonds can be guesswork. Fortunately, several independent companies have taken the work out of evaluating these bonds for you. These are the bond rating agencies; their sole purpose is to analyze entities that issue bonds and determine the likelihood of their defaulting on their debts.

There are a number of ratings agencies, but the three largest are Moody's, Standard and Poor's, and Fitch. Moody's is by far the largest of these services, and most often when you see a rating for a bond in an advertisement or financial analysis, it is this company's grade which is used.

The grading system is rather simple - it mimics, in some ways, the grading system we are all used to from school, with a slight variation. For example, bonds rated as "prime," get a "AAA" rating. Think of this as an A+ on a school report card. Bonds rated "excellent" get an "AA," and those considered "upper medium" get an "A" (like an A- in school). The next tier follows a similar pattern: "BBB," "BB," and "B," in order of least speculative to most speculative. For the most part, all three of these companies use a similar rating system, though Moody's uses "Aaa, Aa, A, Baa, Ba, B" and so on for their grades. Ratings of less than a B - "CCC," "CC," "C," or "D," (Moody's lowest rating is a "C") are considered "junk bonds," bonds that are so speculative that there is no guarantee you'll ever get repaid. The upside to junk bonds is that interest rates are often much higher, and the cost lower than those with better rating. As always with investment opportunities, with risk comes the best chance of reward or failure.

All three of these companies evaluate the different bonds and issuers on a daily basis, and if they see any change in the potential for a company to default, they will adjust their ratings accordingly. This is known as upgrading or downgrading, and can have a big effect on the price of a bond that you hold. Of course, if you're not planning on selling your bond, this will be of less interest to you. Still, should a company or municipal agency which issued your bond have their rating downgraded, you may want to consider the ultimate safety of your long-term investment.

Bond rating agencies are invaluable to the investor. There is no guarantee, though, that just because one of these agencies gives a bond a high rating, it won't go into default. No one agency is necessarily better than another, despite the difference in their popularities. If you are interested in buying a bond, your best bet would be to look at the ratings from across the board, do some research, perhaps even speak with an investment advisor, and come to your own conclusion.

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