Credit ratings were developed to provide a way to assess a company's financial strength, and its likely ability to repay investors in a timely manner. Ratings can be an important indicator of an issuer's financial stability, as well as a helpful tool in determining the relative safety of buying a company's debt. However, ratings alone tell only part of the story. Learn why you, as a bond investor, should not limit your bond investing criteria to credit ratings, and which additional criteria you should examine before making a bond investment. (For further reading on corporate ratings, check out the article What Is A Corporate Credit Rating?)

TUTORIAL: Bond Basics

Potential Weaknesses of Credit Ratings
While credit ratings are helpful tools in making an investment decision, they're not perfect. Below, we'll go over some of the weaknesses associated with credit ratings.

Based on Potentially Biased Information
Credit rating agencies are not independent auditors. They assign ratings primarily on the basis of financial statements that the issuing company or government provides to them. Agency analysts do not undertake independent research, they analyze information and use statistical models to determine the likelihood of default based on the information the issuer provides. If the issuer provides faulty or incomplete information, the agency's rating will be based on that incorrect information.

Cannot Account for or Predict Fraud
Because credit rating agencies work with information that the issuer provides, they cannot predict potential defaults due to fraudulent activity on the issuer's part. (Be sure to read our Investment Scams Tutorial to learn more about fraudulent activity within companies.)

Not Fully Objective
Rating agencies have come under some scrutiny regarding their ability to remain objective when the majority of their income comes from fees paid by the bond-issuing organizations that they are rating. In addition, bond issuers can hire agencies for consulting advice on how to best structure securities in order to get a positive rating. Also, because rating agencies work so closely with their customer firms, the possibility that analysts could assign a slightly, more or less, favorable rating based on personal relationships with executives in companies or governments issuing debt always exists. (Check out The Debt Rating Debate to see how lack of competition and potential conflict have called the value of these ratings into question.)

Lagging Indicators
Because agencies assign ratings based on past corporate and market performance, they are considered "lagging indicators." This means that the agency's ratings changes typically come after it would be beneficial for an investor to make the change to either buy, if the rating improves, or sell, if the rating drops.

Are Bond Ratings Still a Helpful Investment Criterion?
Given all their potential weaknesses, investors may wonder whether ratings are still worth assessing. The answer is yes. While not infallible, ratings provide an important determinant of a company's demonstrated historical ability, and therefore inferred future ability, to perform on its debt commitments. In addition, ratings analysts, while human, still provide a critical expert assessment of a company's financial health. Investors should consider credit ratings as one important piece of their bond investment decision-making process. (Learn more about bond-investing basics in Get Active In Your Bond Portfolio.)

Other Factors to Evaluate for Potential Bond Investment
Seasoned bond investors know that ratings alone should not guide their investment choices. So what other factors should you carefully consider?

Call and Put Provisions
Call and put provisions are redemption features that can change how long you maintain your bond investment. If you want the protection, that comes from knowing you can oblige the bond issuer to repurchase your debt investment before it matures and repay your principal, you'll want a bond that has put provisions. Put provisions are especially important if the interest rate environment changes significantly, and you want to move out of your bond investment and reinvest your money into a security that offers a more attractive rate. Likewise, make sure you know if the bond has a "call provision" that allows the issuer to repay you for your investment before the bond's stated maturity date. (To learn more about provisions, read The ABCs Of The Bond Market.)

Issuer's History of Credit Downgrades
A bond will be downgraded - assigned a lower rating than it was initially given - when something changes, either with the bond itself or the underlying economic fundamentals of the company, government or organization that issued the bond.

Offsetting Compensations for Investors in Event of Downgrade
Some issuers will take proactive measures in order to assure potential investors of their commitment to performing on their debt securities by offering some form of compensation if the security is downgraded.

Investment Goals and Objectives and the Bond's Features
While it may seem obvious, in addition to examining the financial health and ability of a bond's issuer, it's important to know the bond's features (i.e. duration, yield, maturity, etc.), and how those features match up with your investment goals. For example, consider an 'AAA'-rated bond with a 20-year maturity. While the bond has a very attractive and competitive 'AAA' rating, if your primary bond investment objective is to realize high yields, you may also want to consider bonds with lower ratings.

Bonds with lower ratings have correspondingly higher yields, as they are going to have to pay higher yields to attract investors. However, if your primary bond investment objective is to minimize your interest rate risk, a highly rated bond will put you at a greater risk for interest rate changes, compared to a bond with a lower credit rating and shorter maturity. This is because of its long maturity period. (Be sure to check out our Advanced Bond Concepts Tutorial to learn more about the features of bonds.)

Expenses and Fees
Bonds are typically priced with a built-in markup that includes the broker, or dealer's, profit. If your broker, or dealer, does not have a bond in his or her inventory that you are considering for investment, you may need to pay an extra commission fee. Most dealers keep a fairly substantial portfolio of previously-issued bonds for their clients. If you are investing in a bond fund, you may have to pay an annual management fee. Also, if you invest in a bond fund or bond unit investment trust, you may have to pay a small sales fee. (Read Don't Let Brokerage Fees Undermine Your Returns to learn how smart investors don't give away more money than necessary in commissions and fees.)

The Bottom Line
Know why you're investing in bonds, and carefully read the prospectus for the bond issue you're considering before you make a choice based solely on its rating. Although a credit rating can be quite useful, it does not provide a complete picture of the bond, and there are other factors that need to be taken into consideration.

Related Articles
  1. Bonds & Fixed Income

    Junk Bonds: Everything You Need To Know

    Don't be fooled by the name - junk bonds may be for you if you know how to analyze them.
  2. Bonds & Fixed Income

    Are High-Yield Bonds Too Risky?

    Despite their reputation, the debt securities known as "junk bonds" may actually reduce risk in your portfolio.
  3. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  4. Personal Finance

    The Debt Ratings Debate

    Lack of competition and potential conflicts of interest have called the value of these ratings into question.
  5. Mutual Funds & ETFs

    Fatal Seduction Of The Municipal Bond Insurers

    Learn how a foray into CDOs and other exotic products ruined an industry's image.
  6. Budgeting

    Key Questions to Ask Before Moving in Together

    Moving in together is a big step. Here are some key financial questions to ask your partner before you make the move.
  7. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  8. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  9. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  10. Stock Analysis

    The Biggest Risks of Investing in Berkshire Hathaway Stock

    Learn about the risks of investing in Berkshire Hathaway. Understand how issues of succession, credit downgrade risk and increased regulation could hurt it.
  1. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  2. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  3. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  4. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  5. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>
  6. How do I use the holding period return yield to evaluate my bond portfolio?

    The holding period return yield formula can be used to compare the yields of different bonds in your portfolio over a given ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  4. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  5. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  6. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!