Credit Check: Know the Bond Ratings
Corporate bonds and some municipal bonds are rated by financial analysts at Standard & Poor's (S&P) and Moody's, among others. The ratings indicate the credit worthiness of the bond issuer and are, therefore, a report card of sorts on the company issuing the bond. Analysts look at the track record and financial situation of the company, the rate of income, and the degree of risk associated with the bond. All of this information is put together, and the bonds are graded. This is very similar to a personal credit rating, where people who are more likely to pay their debts in full and on time get higher scores than people who may not pay on time, or at all.
A rating or grade of AAA goes to the highest quality bond. Bonds rated AAA, AA, A, or BBB (Aaa, Aa, A, or Bbb in Moody's system) are considered high-quality. BB or B bonds are more questionable. Anything below B, such as C- or D-level bonds, are considered low-grade or junk bonds. However, if you pick the right rising company, a junk or high-yield bond can be very successful. But the risks are high, especially the default risk.
How do bonds pay interest?
A fixed interest rate is the most common, although interest can be paid at a floating rate, which changes based on economic conditions. Zero-coupon bonds pay no ongoing interest. Rather, they are sold at a deep discount and redeemed at full value, causing them to build up, through compounding interest, to their face value.
If you own corporate bonds that used to be solidly rated but have fallen on hard times, you have two choices: sell or hold. Part of your choice will be based on whether you believe the company will turn itself around and get back in the black; the other side of the decision is more immediately practical. If you don't believe the company will ever be able to pay its debts, get out while you can; if you believe the company will pull through — and maybe even emerge stronger — consider keeping the bonds. When the bond is in your portfolio primarily for income purposes (i.e., regular interest payouts that you count on as income), and that income stream is still flowing, it can make sense to hold on to it. On the other hand, if the bond is used as a hedge against riskier stocks or to give you a big lump of cash down the line, consider selling right away, before the bond price drops so low that you won't recoup a sizeable chunk of your investment.
Bond ratings for an issuer can change over time. A company issuing BBB bonds may become a much more stable fixture as a largely successful company, and their bonds may be A-rated next time they are graded. The opposite can happen as well: Highly rated corporations can fall on hard times and have their debt downgraded, sometimes substantially. It's a good idea to keep tabs on the grades of the bonds you own for the purpose of potential resale, as the grade does affect the bond's marketability.
