Q: 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?
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.