Understanding Bond Ratings & How They Affect Returns
If you’re thinking about adding bonds to your investment portfolio, one of the first things you’ll run into is something called a bond rating. These ratings like AAA, BBB, or junk aren’t just random letters. They tell you how likely a bond is to pay you back.
In simple terms:
The higher the rating, the safer the bond. The lower the rating, the more risk and potential reward you’re taking on.
Let’s break down what bond ratings mean, how to read them like an informed investor, and how they affect both your returns and risk.
What Are Bond Ratings?
Bond ratings are grades assigned by agencies like Moody’s, S&P, and Fitch to indicate how creditworthy a bond issuer is. Think of them like a credit score but for governments or companies.
They measure how likely the issuer is to make interest payments and return your principal on time.
Who Assigns These Ratings?
The “Big Three” credit rating agencies:
- Moody’s
- Standard & Poor’s (S&P)
- Fitch Ratings
Each agency uses its own scale, but they all follow a similar structure.
Bond Rating Scale: From AAA to Junk
Here’s a quick breakdown of the bond rating tiers and what they mean:
Rating | Grade Type | S&P/Fitch | Moody’s | Risk Level | Example |
---|---|---|---|---|---|
AAA | Investment Grade | AAA | Aaa | Lowest risk | U.S. Treasury Bonds |
AA | Investment Grade | AA+, AA, AA− | Aa1, Aa2, Aa3 | Very low risk | Microsoft, Johnson & Johnson |
A | Investment Grade | A+, A, A− | A1, A2, A3 | Low risk | Toyota, Walmart |
BBB | Investment Grade | BBB+, BBB, BBB− | Baa1, Baa2, Baa3 | Moderate risk | Some utility or telecom firms |
BB & below | Non-Investment Grade (Junk) | BB+, BB, B and lower | Ba1 and lower | High risk, higher yield | Startups, distressed firms |
Bonds rated BBB- (S&P) or Baa3 (Moody’s) and above are considered “investment grade.” Anything below that is “junk” or high-yield.
How Do Bond Ratings Affect Your Returns?
Here’s the trade-off:
The lower the bond rating, the higher the return needs to be to compensate you for the risk you’re taking.
Let’s look at a simplified yield comparison based on 2025 averages:
Bond Rating | Average Yield (2025) | Risk of Default |
---|---|---|
AAA | 4.00% – 4.50% | Extremely low |
AA | 4.50% – 5.00% | Very low |
A | 5.00% – 5.50% | Low |
BBB | 5.50% – 6.00% | Moderate |
BB (Junk) | 6.50% – 8.00%+ | High |
So, a BB-rated corporate bond might pay nearly double the interest of a AAA-rated bond but with a significantly higher chance of not paying you back.
Why Bond Ratings Matter for Everyday Investors
If you’re building a bond ladder, creating a balanced portfolio, or just trying to earn passive income, bond ratings help you:
- Gauge risk
- Compare yields intelligently
- Avoid default-prone issuers
Real-World Example:
Let’s say you’re offered two bonds:
- Bond A: 5-year, A-rated, 5.1% yield
- Bond B: 5-year, BB-rated, 7.4% yield
Bond B pays more, but there’s a real chance the company behind it struggles financially. If you need stability (say, you’re nearing retirement), Bond A may be worth the lower return.
Should You Avoid Junk Bonds?
Not necessarily.
High-yield (junk) bonds can be part of a diversified strategy especially if you:
- Have a higher risk tolerance
- Can spread your investment across multiple issuers
- Are aiming for higher income over growth
But if safety and steady returns are your goals, stick to investment-grade bonds (BBB or higher).
Tips for Using Bond Ratings Wisely
- Don’t chase yield blindly. If a return seems too good to be true, check the rating.
- Use bond ETFs or mutual funds to diversify if you’re not buying individual bonds.
- Balance your bond mix. A blend of A- to BBB-rated bonds often gives a good balance of return and reliability.
- Check for recent downgrades. A bond that was investment-grade last year may now be junk.
Final Thoughts: Ratings = Your Risk Compass
Bond ratings simplify what would otherwise be a complex game of guessing whether a company or government can repay you. They help you make informed decisions based on your risk appetite.
As you build or rebalance your portfolio, use ratings as a guide not gospel. Pair them with a solid understanding of your timeline, goals, and income needs.
Next Up: Interested in tax-advantaged investing? >> Is Investing in Municipal Bonds Worth It?
That post will dive into how muni bonds work, when they make sense, and why they might be a great fit especially for higher earners in 2025.