Using Bond Ratings to Evaluate Investment Quality
Evaluating investment quality is an important part
of any investment decision. However, with some
investments, quality may be difficult to judge.
For example, if you're considering a bond that has
been issued to finance a project hundreds of miles
away, you probably won't be able to drive by the site
to evaluate the project. You also might not have the
time or expertise to investigate the issuer's financial
stability. You can read the offering documents and
financial statements but may still be unable to make a
professional judgment.
That's where bond ratings can help. In 1909, John
Moody originated a system of rating securities to
provide investors with a relatively simple way to
evaluate investment quality. Today, two investment
rating services are primarily used in the securities
industry: Moody's and Standard & Poor's. They are
similar in the way they classify bonds, and they are
the most used and respected rating services available.
To help you understand bond ratings, let's look at
the Moody's system. Moody uses nine major symbols to
rate bonds. From highest to lowest in investment
quality, they are Aaa, Aa, A, Baa, Ba, B, Caa, Ca and
C. The lower the rating, the lower the investment
quality. The Standard & Poor's ratings are similar.
From highest to lowest in investment quality, they are
AAA, AA, A, BBB, BB, B, CCC, CC, C and D.
Some bonds may be non-rated (NR). In some cases,
this indicates low investment quality. In other cases,
bonds may be non-rated for reasons unrelated to
quality. For example, because issuers of tax-free and
corporate bonds must apply for a rating and pay a fee,
they may decide simply to not apply. A bond may also
be non-rated if the issue is very small, if there is a
lack of essential data relating to the issuer or if the
issue is privately placed with institutional investors.
In addition, ratings are not permanent. Many
bonds are long-term, and circumstances affecting their
ratings may change over time. Issuers of previously
rated bonds are periodically reviewed by the rating
services. If their financial condition changes, so may
the bond rating. The current rating reflects the best
judgment of investment quality at the current time.
Therefore, when purchasing tax-free or corporate
bonds, it is vital to monitor ratings regularly to be
aware of any changes in investment quality.
