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Types of Bonds

How Do Credit Ratings Affect Yield?

The leading rating agencies assess most issuers of corporate bonds as to their ability and willingness to pay interest and repay principal as scheduled. These agencies use quantitative tools and qualitative judgments to evaluate the creditworthiness of an issuer and have developed a grading system from which they assign credit ratings to these issuers. Usually, only bonds issued by the largest and strongest companies qualify for the prized “investment-grade” ratings, which indicate outstanding relative credit. The highest-quality rating is triple-A. The rating levels descend to triple-C as the possibility of default increases and finally to D, or default. Bonds considered to carry minimal likelihood of default are “investment grade” and are rated Baa3 or higher by Moody’s, or BBB- or higher by Standard & Poor’s and Fitch Ratings. Those companies rated below Baa3 or below BBB- are considered “speculative grade.” They have a higher risk of default and are classified as high-yield bonds, as are some types of non-rated bonds. The table below describes the rating assignments for both investment-grade and below-investment-grade debt.

Bond Credit Quality Ratings
Rating agencies
Credit Risk Moody’s* Standard & Poor’s** Fitch Ratings**
Investment grade
Highest quality Aaa AAA AAA
High quality (very strong) Aa AA AA
Upper medium grade (strong) A A A
Medium grade Baa BBB BBB
Not investment grade
Lower medium grade (somewhat speculative) Ba BB BB
Low grade (speculative) B B B
Poor quality (may default) Caa CCC CCC
Most speculative Ca CC CC
No interest being paid or bankruptcy petition filed C D C
In default C D D

* The ratings from Aa to Ca by Moody’s may be modified by the addition of a 1, 2 or 3 to show relative standing within the category.

** The ratings from AA to CC by Standard & Poor’s and Fitch Ratings may be modified by the addition of a plus or minus sign to show relative standing within the category.

To entice investors and to compensate them for the attendant risks, issuers with lower-rated credits must pay a higher rate of interest than companies whose bonds are given an investment-grade rating. This in turn generates a higher “yield” for investors. For example, suppose a company that qualifies for the highest rating (AAA/Aaa) issues a 10-year bond with a yield of 6%. To compete for capital, a company rated single-B may need to offer a yield of 9% to 11%.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.