The fact that creditors (bondholders) have precedence over owners (shareholders) does not mean that bonds are without risk. Certainly, federal bonds are the closest thing to a risk-free investment you will find, but any corporation or any other level of government has some chance of defaulting on an issue or ending up insolvent. Credit risk or default risk is the possibility that an issuer will be unable to pay off the principal or even make the interest payment. The higher an issuer's credit risk, the lower the price and the higher the yield on its bonds.
Companies such as Moody's and Standard & Poor's specialize in rating credit. These bond ratings measure quality and safety based on the issuer's financial condition. These rating services evaluate the likelihood that a debt issuer will be able to meet scheduled interest and principal payments.
The Standard & Poor's Rating Hierarchy:
- The highest ratings - AAA, AA and A - are awarded to companies with a solid, proven record of paying interest and principal in a satisfactory manner.
- BB, B, CCC and so on down the line indicate less stellar performers.
The following table provides a side-by-side comparison of Moody's and S&P's rating scales. The scale for corporate bonds is the same as that for municipal bonds. Moody's Baa rating, corresponding to S&P's BBB, represents the lowest investment-grade bonds; everything below that line is considered speculative, and issuers are expected to offer higher yields to offset the higher perceived risks.
|Moody\'s vs. Standard & Poors Bond Ratings|
|Aaa||AAA||Investment, Highest Quality||Lowest Risk|
|Aa||AA||Investment, Very High Quality||Low Risk|
|A||A||Investment, High Quality||Low Risk|
|Baa||BBB||Minimum Investment Grade||Medium Risk|
|Ba||BB||Junk, Speculative||High Risk|
|B||B||Junk, Very Speculative||Higher Risk|
|Caa||CCC||Junk, Default Possible||Higher Risk|
|Ca||CC||Junk, Default Probable||Extreme Risk|
|C||D||Junk, In actual or imminent default||Highest Risk|
For investors considering buying debt securities, a credit rating is an essential tool. Read more about the importance of credit ratings in the article What is a Corporate Credit Rating?.
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