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Bonds - Major characteristics: Credit Quality and ratings
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Credit quality: pay attention to the entity you lend.

Credit quality of the borrower (issuer) is an important factor to look at before purchasing a bond (and consequently lend to the issuer). The credit quality of the issuer reflects its financial abilities to fulfill his payments. When the bond is issued, you can find details of the financial soundness of the issuer in the prospectus of the bond.

The price you pay for the bond and the yield you get from your investment depend of the credit quality of the issuer. The less the credit quality of the issuer is, the less you pay for the bond.

But the ability to repay can change during the lifetime of the bond and it is very difficult for the private investor to follow up regularly the credit quality of the issuer. But that's the work of the rating agencies.

Rating agencies are paid by the issuer and assign ratings to many bonds when they are issued and monitor the credit quality of the issuer during the bond's lifetime.

The most known rating agencies are Moody's Investors service (Moody's), Standard & Poor's Corporation (S&P), and Fitch (Fitch). Both companies assign ratings to issuers and bonds following their own scheme (see table below). These ratings are public and can be found in some newspapers, books, and internet.

 

CREDIT RATINGS

Credit Risk

Moody's

S&P

Fitch

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 or HIGH YIELD

Somewhat speculative

Ba

BB

BB

Speculative

B

B

B

Highly speculative

Caa

CCC

CCC

Most speculative

Ca

CC

CC

Imminent default

C

C

C

Default

C

D

D

You can see from the above table that bonds are classified as Investment grade and non investment grade (Junk Bonds).

It is very important to understand that if a bond pays you a high interest rate, it goes often together with a low rating and an higher risk.

The high yield risk can be significantly reduce by diversification. That's the reason why most of the private investors that are looking for higher yields, enter the junk bond market via a specialized fund.

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