How a Corporation’s Credit Rating Relates to Risk and Returns - dummies

How a Corporation’s Credit Rating Relates to Risk and Returns

The largest determinant of the risk and return you take on by investing in bonds is the fiscal strength of the company behind the bond. A company’s credit ratings are the measure of that financial muscle.

An entire industry’s devoted to rating companies by their financial strength. The most common ratings come from Moody’s and Standard & Poor’s, but there are other rating services, such as Fitch Ratings, Dominion, and A.M. Best. Your broker probably subscribes to at least two of these services and will be happy to share the ratings with you.

The highest ratings — Moody’s Aaa and Standard & Poor’s AAA — are the safest of the safe among corporate bonds, and those ratings are given to few corporations. If you lend money to one of these stellar companies, you should expect in return a rate of interest only modestly higher than Treasury bonds. As you progress from these five-star companies down the ladder, you can expect higher rates of interest to compensate you for your added risk.

The following table shows how Moody’s, Standard & Poor’s, and Fitch define corporate bond credit quality ratings.

Credit Risk Moody’s Standard & Poor’s Fitch
Investment grade
Tip-top quality Aaa AAA AAA
Premium quality Aa AA AA
Near-premium quality A A A
Take-home-to-Mom quality Baa BBB BBB
Not investment grade
Borderline ugly Ba BB BB
Ugly B B B
Definitely don’t-take-home-to-Mom quality Caa CCC CCC
You’ll be extremely lucky to get your money back Ca CC CC
Interest payments have halted or bankruptcy is in process C D C
Already in default C D D

Keep in mind that one risk inherent to corporate bonds is that they may be downgraded, even if they never default. (Default in bond-talk means that you bid adieu to your principal.) Say a bond is rated A by Moody’s. If Moody’s gets moody and later rates that bond a Baa, the market will respond unfavorably. Chances are, in such a case, that the value of your bond will drop.

Of course, the opposite scenario applies, too. If you buy a Baa bond and it suddenly becomes an A bond, you’ll be sitting pretty. If you wish to hold your bond to maturity, such downgrades and upgrades are not going to much matter. But should you decide to sell your bond, a downgrade can matter very much.