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A bond rating is a rating that independent agencies issue to measure the credit quality of a particular bond. The bond rating measures the financial strength of the company issuing the bond, and its ability to make interest payments and repay the principal of the bond, when due.

Standard & Poor's, Moody's, and Fitch Ratings are the major bond-rating agencies. Although their rating systems are slightly different, the coveted triple-A rating indicates the cream of the crop that every bond issuer strives to achieve. Below, we'll look more closely at bond ratings and what they mean.

Understanding bond ratings

Thousands of government agencies and private companies look to raise capital by issuing debt, and the bonds that they sell are popular investments among those looking for fixed income. However, the depth of the bond market can make it difficult for investors to assess whether one company is more or less likely to repay its debt than another. In order to simplify comparison of different bonds, bond-rating agencies make it their specialties to issue bond ratings for different bonds.

Bond ratings use a combination of letters, numbers, and symbols to indicate their relative placement on a given agency's rating scale. Letters generally indicate a broad range of ratings. Having more letters in the rating is generally better than fewer letters, and being earlier in the alphabet indicates higher quality.

For Standard and Poor's, AAA is the best rating, followed by AA, A, BBB, BB, B, CCC, CC, and C. D is used for bonds that are already in default. Fitch's ratings are similar to S&P. Moody's uses a slightly different scale, but its Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C ratings have roughly the same meaning.

From there, numbers or symbols further break down the letter-based rating. For example, with S&P and Fitch, a rating of AA+ is better than AA, and a rating of AA- is worse than AA, but better than A+. Moody's uses numbers to indicate relative quality, with Aa1 being the best Aa rating, followed by Aa2 and Aa3.

The key line in the sand with bond ratings

In general, the higher the bond rating, the more favorable the terms will be for the bond issuer. High-rated bonds have lower interest rates because investors need less compensation for the risk of default. That leads to lower borrowing costs for bond issuers.

However, there's one particularly important breakpoint in bond ratings. Bonds rated BBB- or Baa3 or above are treated as investment grade, which means that most institutional investors are permitted to own the bonds. By contrast, bonds rated BB+ or Ba1 or worse, are treated as high-yield bonds, which many refer to as junk bonds. These are seen as more speculative, and many institutional investors either shy away from them, or have limits on how much they can invest.

Bond ratings aren't a perfect indicator of what will happen with a particular bond, and ratings haven't always worked in the way they were intended. Nevertheless, as a measure of relative strength, bond ratings are a good starting point for research on a company's debt.

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