Section 3.3 — Bond Ratings and Volatility

  • 💡 Purpose of Bond Ratings

    • Before purchasing bonds, investors often look at bond rating services to gauge how safe an issuer is (the borrower’s ability to repay).

    • The Three Major Rating Agencies (SEC-Recognized):

      • Standard & Poor’s (S&P)

      • Moody’s Investors Service

      • Fitch Ratings

      BThe most widely referenced are Standard & Poor’s and Moody’s.

🧾 Bond Rating Scale

Category / S&P / Moody’s / Description

  • Highest Quality (Prime) / AAA / Aaa / Extremely strong capacity to meet obligations

  • High Quality / AA / Aa / Very strong capacity

  • Upper Medium Grade / A / A / Strong capacity, somewhat susceptible to conditions

  • Lower Medium Grade (Investment Grade) / BBB / Baa / Adequate capacity but more vulnerable

  • Speculative (Non-Investment Grade / Junk) / BB / Ba / Faces major uncertainties or exposure to adverse conditions

  • Highly Speculative / B / B / More likely to default

  • Poor or Default / CCC–D / C–D / Currently vulnerable or in default

💰 Investment Grade vs. High-Yield (Junk)

  • Investment Grade Bonds:

    • Ratings of BBB / Baa or higher.

    • Considered safe and stable.

    • Eligible for purchase by institutions (banks, insurance companies, fiduciaries).

    • More liquid — easier to sell.

    • Lower yield (less risk).

  • High-Yield (Junk) Bonds:

    • Ratings of BB / Ba or lower.

    • Higher risk of default, higher volatility.

    • Higher yields to compensate for added risk.

    • Can drop sharply during economic downturns.

📉 Relationship Between Rating and Yield

  • Higher rating → Lower yield (less risk)

  • Lower rating → Higher yield (more risk)

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⚖️ Bond Volatility

  • Bond prices move inversely to interest rates.
    The degree to which a bond’s price moves when interest rates change is called its volatility.

  • Two main factors affect bond price volatility:

1. Time to Maturity:

  • Longer maturities = more volatile prices.

  • Example: A 10-year bond is more volatile than a 5-year bond.

2. Coupon Rate:

  • Lower coupon rate = more volatile price.

  • Example: A 3% bond is more volatile than a 6% bond with the same maturity.

⏱️ Duration — Measuring Volatility

  • Duration combines maturity and coupon rate into a single measure of volatility.

  • Higher duration = greater price volatility.

  • Lower duration = more price stability.

  • Can also be used to measure the volatility of an entire bond portfolio.

⚖️ Summary Table

Concept / Definition / Effect

  • Bond Rating / Measure of issuer’s creditworthiness / AAA = strongest

  • Investment Grade / BBB/Baa or higher / Safe, low yield

  • High-Yield (Junk) / BB/Ba or lower / Riskier, higher yield

  • Volatility / Sensitivity of bond price to rate changes / Inversely related to rates

  • Maturity / Time until principal is repaid / Longer = more volatile

  • Coupon Rate / Annual interest paid / Lower = more volatile

  • Duration / Combined measure of volatility / Higher duration = higher risk

Next Section

✺ Review questions ✺

  • Fitch, Moody’s, and Standard & Poor’s

  • Investment grade

  • Institutions and fiduciaries (like banks and insurance companies)

  • Inversely — when rates rise, prices fall.

  • 10-year 3% bond (longer maturity and lower coupon)

  • The overall price volatility combining maturity and coupon rate.

  • High-yield (junk) bonds