- Each bond has a maturity date, which is the time when the issuer must retire the bond by paying the bond owner the face value of the bond. However, most bonds carry at least some risk of default, which means there's a chance the company or government agency may not be able to repay the debt represented by the bond. This is a rare occurrence with some types of bonds but more likely with others. If the bond has a maturity date many years in the future, the financial condition of the bond issuer could change over that time period. Bonds are rated for the default risk they present based on the financial condition of the bond issuer.
- Treasury bonds and other federally-issued bonds are considered to have virtually no default risk and are not rated by bond rating services. Municipal bonds (also called "munis") are issued by state or local governments. By and large, these are extremely safe investments. However, you will occasionally see a government agency run into financial problems, especially during economic downturns. As a result municipal bond defaults are rare, but do occur. Corporate bonds are issued by private companies. Some have very high bond ratings and are considered safe, while others can present a serious risk of default and as a result are rated low.
- Companies are rated for default or credit risk just as individuals are. There are three major ratings services: Standard & Poor's, Fitches Ratings and Moody's. These services analyze the revenue prospects and overall financial condition of issuers of municipal and corporate bonds and publish their evaluations in the form of bond ratings. The safest bonds are rated AAA, Aaa or AA. Next are bonds rated A or BBB (Moody's uses the designation Baa). Bonds with lower ratings are not considered investment grade. The lowest rated bonds are those where the issuer is in bankruptcy, default or is unable to make interest payments. These bonds are designated C or D (see References 1).
- Bond rating services provide invaluable guidance for investors by making risk estimates easily accessible. Ratings also have an important influence on bond prices. If a bond rating is reduced, the price of the bond normally falls in response because investors are not as willing to purchase higher risk securities, at least at the existing price. However, bonds pay a fixed amount of interest. When the bond price drops, this means an investor pays less to get the same amount of interest income, so the yield (effective interest rate) increases. The increased yield makes the bond more attractive for investors who are willing to accept increased risk in exchange for a better return.
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