As with stocks, the strength of the issuer greatly affects a bond's quality. With the exception of the U.S. Treasury, issuers introduce credit risk, or the risk that a bond will go into default. This happens when the bond issuer is unable to pay interest or fails to repay principal at maturity.
Bond rating companies, like Standard & Poor's, Moody's Investors Service, Inc., and Fitch Ratings, research and rate bonds by concentrating primarily on assessing their credit risk. Rating services look at the financial stability of the issuer, its other outstanding debt (if any), its growth potential, the state of the economy, and how well similar entities -companies in the same line of business or municipal governments in the same condition - are doing. They assign ratings to municipal, corporate and international bonds to help you make informed investment decisions. Treasury bonds are not rated because they are the only debt instruments assumed to be free of credit risk.
Rating services each use slightly different methods to rate bonds.
Standard & Poor's uses capital letters A through D, with AAA being the best rating and D, the worst. Any bond rated AAA through BBB is considered investment grade, while any rating of BB or lower is speculative grade. Small variations in risk are noted with (+) or (-) symbols. Moody's uses both letters and numbers to rate bonds, with Aaa having the highest rating and C the lowest. Small variations in risk are ranked with the numbers 1, 2 and 3. Moody's ranks any bonds with ratings of Baa and above as investment grade.
Bonds with the same rating may offer varying interest rates, depending on their respective terms. Under most market conditions, those with longer terms tend to pay higher interest rates.
The lower a bond's rating, the greater the risk of default. To compensate for the elevated credit risk, bonds with lower ratings typically pay higher interest rates than those with higher ratings. Junk bonds are the lowest-rated corporate and municipal bonds and have the greatest risk of default, but generally pay the highest rates. Some people choose to invest in junk bonds because of the earning potential, but take additional market risk - in addition to credit risk - when doing so because prices tend to be volatile.
One risk that investors cannot anticipate is whether a rating service will downgrade a bond that has already been issued a rating. When bonds are downgraded, investors demand higher prices to counterweigh the heightened credit risk. Those that fall from investment to speculative grade are known as fallen angels.
The one risk that rating services cannot measure is market risk, or the impact that changing interest rates will have on the price of the bond if you sell it before maturity. This is because any type of bond, no matter how high its rating, is susceptible to changing market forces.