Before investing in a bond, or any other investment vehicle for that matter, an investor should understand the risk involved in their purchase. A helpful ratings system has been established to help those interested in investing decide which option is the right one for them.
Bond ratings are established by three different bodies: Standard & Poor’s, Moodys Investors Services and Fitch Investors Services. The ratings vary from AAA, highest investment quality, to D where payment is in default. The three bond ratings services develop their ratings based on an in depth analysis of the company and their financial state. These ratings can help an investor determine if their purchase is a safe bet, or a risky venture.
A bond is a debt investment. Companies or governments borrow money from investors for a specified length of time and at a set interest rate to supplement their finances. In exchange for being allowed the use of the investor’s money, the bond issuer will pay the set interest rate. However, some companies are higher risk than others, such as a company that defaults on their loans and does not honor their bonds, resulting in a loss for the investor.
Generally, companies or governments with in an unhealthy financial situation are willing to pay more in interest to attract investors. This is why lower-rated bonds seem to pay off better, but the investor has to consider that they may not receive any return on their investment at all if the company defaults on the loan. While AAA bond ratings pay a lower rate of interest than D bond ratings, the investor is almost certain to actually receive the return promised by the bond issuing company.
Each investor receives a bond certificate from the issuing company, stating the loan amount and the date it is to be repaid. A bond with a term of 2 years, for example, will mature at that time and the investor will receive their capital investment back along with any interest owing. Most companies will also pay interest in increments, resulting in a bi-annual or annual interest pay out for the investor.
Research and knowledge are just as important in bond investing as in stock trading. While the bond ratings can help the investor make a decision, they should also look into the company’s history and financial track record themselves before placing their loan in trust through a bond. A diversified portfolio could include a few high-risk, low-rated bonds, but must be balanced out with safer investments.