HOW TO INTERPRET BOND RATINGS

Bond ratings are published to aid investors in analyzing the risk of a given bond.  While these ratings are credible, they are subject to change in response to events that affect a company's ability to meet its obligations.  Therefore, it is wise to continually track a bond's rating, since an upgrade or downgrade can significantly alter the bond's market price.  If a bond is upgraded, say from A to Aa, the bond's market price may increase.  Likewise, if the bond is downgraded, its market price might decrease.

Investors can also use bond ratings to choose a bond that fits their criteria for risk and return.  Generally, a bond with an AAA rating will have a relatively low risk of default.  Yields on such bonds will be closer to the risk-free rate than to the rates of more default-risky bonds.  As ratings become lower, default risk increases.  Investors need incentives to take risk, so yields on higher-risk bonds tend to be higher in order to attract investors.  Therefore, if you are an investor who does not mind taking risks in exchange for the potential of a high return, you may opt for a bond with a low rating.  Conversely, if protecting your capital is more important than gaining a high rate of return, you may opt for a bond with an AAA or AA rating.   

The major split in both Moody's and S&P's rating systems is the division between investment-grade bonds and junk bonds.  Bonds rated BBB (Standard & Poor's) or Baa (Moody's) and above are considered investment-grade bonds.  Any bond with a lower rating is considered a "junk bond."  Junk bonds, also known as high-yield bonds, are low-rated, speculative bonds that have a greater probability of default, but also offer higher potential returns.  They rose to prominence in the 1980s as a tool for corporations to finance takeovers and leveraged buyouts.

Let's summarize what we have learned about bond ratings.