Bond ratings

In a worst-case scenario, a bond goes into default. Default occurs when the bond issuer fails to pay interest as it comes due and/or fails to repay the par value of the bond at maturity.

Independent research firms — including Standard & Poor's, Moody's Investors Service, and Fitch — evaluate many types of bonds and assign each new issue a credit rating to indicate its relative risk of default. And they continue to track the financial condition of the bond's issuer until the bond reaches maturity — sometimes changing the rating they've previously assigned.

Rating criteria

In deciding how to rate a bond, rating services consider:

The bond issuer's overall financial condition

The issuer's debt profile

How fast the company's revenues and profits are growing

The state of the economy

How well similar corporations or governments are doing given the current economic environment.

Investment-grade describes bonds rated Baa or higher by Moody's, or BBB or higher by Standard & Poor's. Junk bonds are the lowest-rated corporate and municipal bonds — meaning there's a greater-than-average chance that the issuer will fail to repay its debt. But you may be willing to take the risk of buying these low-rated bonds because the yields are often much higher than on more highly rated investments. However, the prices are volatile as well, exposing you to additional risk if you have to sell before maturity.

The lower a bond's credit rating, the higher the interest the issuer must pay to attract buyers. And if an issuer's financial condition deteriorates, and the rating services downgrade its bonds, the prices those bonds command in the secondary market drop as well, as investors demand a higher yield for owning the bond. That's one of the risks you take as a bond investor, especially if you anticipate having to sell a bond before maturity.

Alexandra Lebenthal, President and Chief
Executive Officer of
Alexandra &
James, Inc.

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