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What do the credit ratings on bonds mean?

What's the actual difference between a bond rated AAA and one rated AA? At what level is it generally not a good idea to invest?

Jun 13, 2012 by Joss from Clarksville, TN in  |  Flag
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John E. Benedict Level 13

The above are really good answers to how bonds and credit ratings work. Just because a bond has a lower rating doesn't mean you should or shouldn't invest in it. Also keep in mind that one has to be fairly knowledgeable about how individual bonds work. A better approach as suggested could be to look a bond mutual fund or bond ETF instead. Your risk would be spread out among many different issuers which takes some the guessing out of it. Of course you should know on the flip side there is no maturity date on a bond fund or ETF like on an individual issue.

So to sum up: Individual bonds carry more risk and require more due diligence but do have an end maturity date. Bond funds and ETF's carry lower risk due to diversification but have no maturity date. So is a bond fund/ETF right for you even if it is lower quality? Possibly. It would depend on how the rest of your portfolio is invested, your short and long term objectives and goals, and how much risk you can take.

Good Luck.

Comment   |  Flag   |  Jun 13, 2012 from Troy, MI

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George Cones, JD Level 20

Whoa, that is a good question. The ratings services, when they are being sued, say their ratings mean nothing. Based on the many of the products with AAA ratings that crashed and burned over the last several years, one might tend to agree with that assessment. The point is Caveat Emptor, let the buyer beware.

AAA rated bonds can be rated downward and lower credit quality bonds can be upgraded, so these rating regimes must not be seen as definitive. There are skilled active bond fund managers that do their own credit research, in whom we would have much more confidence. If you want to invest in bonds without an actively managed fund, bond index funds or bond index ETFs are a great choice. If you invest in a corporate bond index(s), you will be the proud owner of hundreds or thousands of securities. If one bond bites the dust, then another might get upgraded, so you have less to worry about.

Remember there are other risks in bonds (especially longer duration bonds), so become familiar with those risks as well.

Comment   |  Flag   |  Jun 13, 2012 from Wilmington, DE

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Joss, Credit ratings on bonds reflect the ability of the issuer to pay on the principle and interest promised. Triple A reflect the highest probability that the issuer can fullfill the promise made and as a result are the safest to invest in. That being said, the bond markets in today's world are the most volatile it has been in many years. So take care and becautious when investing in bonds. This link will help with a more in depth picture http://www.treasurer.ca.gov/ratings/moodys.asp
Good Luck

Comment   |  Flag   |  Jun 13, 2012 from Asbury Park, NJ

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Jesse Level 18

To answer your question about the investment merits of a specific bond, it comes down to the risks involved (partially indicated by the bond's rating but this is in no way comprehensive) and the price, which along with the coupon determines the rate of interest you will be paid. Ultimately, successful bond investors are only willing to pay a price for a bond that compensates them for the risks they are taking. Some of these include default risk, prepayment risk, interest rate risk, etc. Clearly, there are a lot of variables to consider. For this reason I typically recommend using a total bond market ETF like this one: https://www.schwabetfs.com/summary.asp?symbol=SCHZ

Comment   |  Flag   |  Jun 13, 2012 from Bend, OR

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