In terms of yield and risk, how much riskier are lower-rated bonds? Ask a Fool
Here's what those letters mean in terms of yield and risk.
Question: I'm shopping for bonds, and while I understand the basic idea of bond ratings, I'm not sure what they really mean in terms of yield and risk. Can you help?
Answer: The general concept of bond ratings is easy to understand. Bonds are rated by three main agencies (S&P, Moody's, and Fitch), and lower ratings imply more risk. However, many investors don't realize the differences in risk and yield between each rating level. (Note: For this discussion, I'm using the S&P rating system of AAA, AA, A, B, etc.)
The highest-rated bonds, AAA, are extremely unlikely to default. In fact, AAA-rated bonds have a 0% default rate since 1981. The historical default rate for AA-rated bonds is 0.02%, followed by 0.07% for A-rated bonds, and 0.22% for BBB-rated bonds.
So even the lowest-rated investment-grade bonds (BBB) have extremely small default rates. Even during the financial crisis, BBB-rated bonds peaked at a 0.54% default rate. It's not until you get into the realm of junk bonds that you'll see default rates of 1% or higher.
As far as yield goes, different ratings can have a big impact, especially with long-maturity bonds. As of this writing, the average yield for a 20-year maturity bond is 4.05% (AAA), 4.25% (AA), or 4.90% (A). For many investors, an additional 85 basis points of yield is worth the additional risk of A-rated bonds, especially since they have just a 0.07% historical default rate.
On the other hand, risk-averse investors are often perfectly content to accept the slightly lower yield of an AAA-rated bond in exchange for the peace of mind that comes with knowing their risk of default is virtually zero.
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