Debt securities are loans that you can buy and sell on the secondary market. When you take out a loan, your lender normally verifies your credit history and takes that information into account along with your current financial situation before issuing the loan. Many investors like to assess the credit quality of bonds, and rated bonds are debt securities that have been assessed by credit agencies. Unrated bonds have not been assessed by rating agencies. Some unrated bonds expose investors to elevated levels of risk, while other types of unrated bonds are among the safest investments on the market.
Fitch, Moody's, and Standard and Poor's are the three credit rating agencies that assess the quality of debt securities in the United States. These firms analyze the financial strength of the bond issuer, the creditor's options in the event of default, and other issues such as the viability of the project being financed. All three firms use a system within which the lowest risk bonds receive AAA or Aaa ratings and the lowest rated bonds receive C or D ratings. If you buy a rated bond, you have an idea of the risk that your are taking. When you buy an unrated bond, you take a leap of faith because no third party can attest to the quality of the security you are purchasing.
Investors expect higher yields when they take on high levels of risk, so the highest rated bonds have the lowest yields and the lowest rated bonds have the highest yields. It can take months for the rating agencies to assess the quality of a bond offering, so some firms bypass the assessment process by releasing unrated bonds onto the market. In such cases, the issuers usually have to offer higher yields than those paid on highly rated bonds because there are no quality guarantees. However, unrated bonds sometimes pay lower yields than the lowest rated bonds because low-rated bonds are known to expose investors to high risk levels, whereas unrated bonds may or may not expose investors to high risk levels.
Municipal bonds are among the highest rated bonds that you can buy because many of these bonds are general obligations bonds, which means the bonds are liabilities of the taxpayers. If the government lacks the money to repay the debt, then it can raise tax revenues to cover the cost. Federal government bonds are perceived as the lowest risk bonds that you can buy, but federal bonds are unrated. However, while federal bonds are not rated, rating agencies do rate the creditworthiness of the federal government as a whole, so investors can use those ratings as a rough guide to the quality of the bonds.
Ratings are not full proof and critics of rating agencies point to the failings of highly-rated mortgage securities from 2007 onwards as evidence that the rating agencies can make mistakes. However, in the absence of ratings, the average investor cannot differentiate between a low risk bond being sold by a financially strong corporation and a highly speculative debt security tied to mortgages with a high default rate. In the absence of clear information, unrated bonds, other than federal bonds, are perceived by some as speculative investments that conservative investors should treat with caution.
- Public Bonds: Municipal Bonds and Defaults
- Wall Street Pit; Unrated Debt an Emerging Global Trend; Ockham Research; October 2009
- Standard and Poor's; Issuer Credit Rating Definitions; April 2011
- Standard and Poor's: Credit Ratings Definitions & FAQs
- Bloomberg; Unrated Bond Sales Increasing in Germany as Investors Chase Higher Yields; Aaron Kirchfield; October 2010