Understanding Credit Ratings

When you buy bonds, you're taking a risk that borrowers with poor credit ratings may not repay their loans on time, if at all. Two major services, Moody's and Standard & Poor's, rate the creditworthiness of bonds. Ratings are based primarily on the credit history and current financial status of the issuer.

The ratings use a letter system. Bonds with only an A in their rating are of high quality. Bonds with a B in the rating are of medium quality (except for Moody's B rating, which is below medium quality). Bonds with a C are either low quality or extremely low quality.

Bonds are commonly labeled either "investment grade" or "high yield" quality (often called "junk" instead). The less creditworthy the borrower is, the higher your risk is of not being repaid what you lent. For that reason, higher risk bonds usually provide a higher interest rate.

You can avoid the issue of creditworthiness entirely by investing in bonds issued by the federal government and its agencies.

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