What Are Bond Fund Ratings?
When you buy a bond fund, you are investing in a large group of either corporate or government bonds. The money you invest is like a loan, which the bond issuer is obligated to pay back. Because bonds are guaranteed by their issuers, they are relatively safe investments. However, not all bond issuers are the same. Bond ratings agencies, such as Moody's and Standard and Poor's, rate bonds based on the ability of their issuers to meet their debt obligations.
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How Ratings Work
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Bond funds are rated based on the type of bonds the fund invests in. Ratings agencies research bond issuers and rate their ability to pay bond interest and repay their loans when their bonds mature. Both major ratings companies provide similar ratings. Bonds rated AAA, for example, are the most secure, whereas bonds rated B and lower are considered highly speculative and are not considered safe for investors who depend on the fixed income bonds provide.
Risk and Reward
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There is a positive relationship between investor risk and reward potential. Investors are typically risk averse. To get them to invest in riskier products, it is necessary to pay them higher returns on their money. As a result, lower-rated bonds are issued with higher bond yields to attract investors.
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Investment Grade
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Investment grade is a term used by bond professionals, which refers to the suitability of bonds for investors who are living on a fixed income, such as retirees or those nearing retirement age. Bond funds that invest in bonds that are rated AAA through BBB are considered investment grade. Bonds with ratings of Ba or BB and lower are sometimes referred to as junk bonds and, while they pay higher yields, they are considered riskier by the bond ratings agencies.
Government Bonds
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U.S. Treasury bonds are not rated by the ratings agencies, but they are considered the safest of all bond types because they are backed by guarantees from the government. Government Sponsored Enterprises, or GSE, bonds are also not rated, but they are insured by the government and are considered as safe as Treasury bonds. GSE bonds include bonds issued by Fannie Mae and Freddie Mac as well as Federal Home Loan Banks, which were bailed out by the government during the 2008 financial crisis.
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