Ask a Fool: What Do Bond Ratings Mean?

Q: I’m shopping for bond investments, and see ratings like AAA, AA, and others. What do these mean?

There are three main bond rating agencies: Standard & Poor’s, Fitch, and Moody’s. The first two use similar ratings, with AAA being the best, followed by AA, A, BBB, BB, B, CCC, CC, C, and D with +/- used to further break down the ratings. Moody’s ratings start with Aaa, then go to Aa, A, Baa, Ba, B, Caa, Ca, and C, and instead of pluses and minuses, use the numbers 1, 2, and 3, in descending order, to break it down further. These ratings are used to convey a particular bond’s risk/reward profile to investors.

Typically, the lowest rating means that a bond is already in default. Any bond rated BBB-/Baa3 or higher is considered “investment grade,” with lower-rated bonds considered “high-yield” or “junk” bonds.

While higher-rated bonds have lower risk of default, they also generally have lower yields. As of this writing, an AA-rated corporate bond with a 10-year maturity yields 3.86%, while a slightly lower-rated A-rated bond of the same maturity yields 4.01%. If you have a low risk tolerance, bond ratings can help you find bonds with virtually no chance of default. On the other hand, if you have the appetite for a little more risk, these ratings can help you construct a fixed-income portfolio with an appropriate amount of risk for you.