Bonds represent a transaction between an investor and a borrower. Much like a loan, a bond represents money an investor gives to a borrower to use however they like, with set rules regarding interest rates and payback terms. Bonds are rated based on the associated risk of default. There are important distinctions between AAA and BAA corporate bond yields.
More About Bonds
Out of the three classes available for investment (cash, bonds and stocks), bonds represent a reliable investment that might have a lower rate of return than stocks, but won't necessarily lose value if the stock market crashes. They're often used in portfolios to balance the gap between cash on hand and stock investments.
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Stock has a higher potential reward partnered with high risk; cash accounts have little risk but no real investment reward. Bonds offer some gain on investment with a reasonably small risk of non-payment, which makes them an important portion of anyone's portfolio.
What Are Bond Ratings?
With so many bonds available, investors look at benchmarkers like Standard & Poor's and Moody's to determine whether a specific bond represents a low risk of default. The low risk of default means the investor has a high chance of payback.
A bond's credit rating isn't quite like an individual's credit score, but it's the same concept: it tells a potential investor whether the entity will be able to repay their money on time with a reliable interest rate, or whether there's a reasonable chance the entity will default. The difference is, in this case, the investor is an individual or a small entity, and the entity is a business, corporation or government.
The main rating agencies publish designations in code that communicate their assessment of a bond in terms of risk and payback interest. Agencies do use different rating systems, but each site provides definitions of what their ratings mean, like this one from Moody's, and combination charts for bonds do exist, like this one from Wolf Street. The accumulated knowledge from these rankings determines how these bonds are viewed on the market.
Consider also: Factors Affecting Bond Rating
More on Bond Ratings
When ratings concur at high levels, bonds are rated as investment-grade; this represents their ability as low-risk investments to deliver on their initial conditions without problems. This category usually includes a few sublevels. Prime is the highest rating a bond can get; below that, bonds within investment-grade quality are listed as high grade, upper-medium grade and lower-medium grade.
Bonds listed at lower levels end up being listed as non-investment grades. This category is defined related to the level of risk versus the potential reward. They're also called high-yield bonds or junk bonds; these terms are based on the higher interest rates these bonds offer in return for a higher risk of non-payment.
Municipal bonds are those offered by formal entities such as cities, states, governments or other entities like nonprofit schools or hospitals. Most of these bonds are assumed to operate at the highest level, as they're backed by a higher institution.
AAA vs. BAA Bond Yields
Within Moody's ratings, AAA bonds and BAA bonds represent opposite sides on the spectrum of bonds included within the investment-grade category; they're both bonds that are recommended based on security and risk.
An AAA bond is the top of the heap; the AAA bond rate is what's called prime. This bond comes with high confidence of repayment including interest rate, and the risk of default is low. A bond rated BAA may be at the bottom of this category, meaning it offers a higher return for higher risk, but both bonds fall into the investment-grade category, meaning the likelihood of bonds paying out true as expected is high enough to achieve this rating.
The difference in yield between an AAA bond (the top) and a BAA bond (at the bottom of the investment grade) represents a yield spread or yield grade. A higher yield grade implies a recession, as investors switch to the more guaranteed returns on AAA bonds. As the recession evolves, BAA investors increase, which reduces the ratio between AAA and BAA.