If you're going to invest in bonds, you have to understand the ratings.

Since the primary function of bonds as an investment vehicle is to make fixed payments, it's essential that the company or government issuing the debt has the ability to make all payments on time and in full. Bond ratings evaluate the debt issuer to determine the risk of default.

Here's how bond ratings work: The leading rating agencies, Standard & Poor's and Moody's Investors Services, assign ratings when a bond is first issued, and that rating helps determine how high the bond's interest rate will be. If the agencies assign a high rating, that means there's little risk of default, so the issuer can obtain a lower interest rate.

The rating agencies assign ratings to all kinds of bonds -- debt issued by corporations as well as bonds issued by foreign governments and U.S. municipal bonds issued by states and localities. Even Treasury bonds issued by the U.S. government have ratings, though they're not generally noted since the risk of default is considered negligible.

The agencies review their ratings on a regular basis to determine if the risk of default has changed over time. If they feel that the level of risk has changed, the agencies may downgrade or upgrade a rating. In addition to having an impact on bond prices, corporate bond rating changes can have a big affect on the issuer's stock price. Likewise, an upgrade or downgrade of a developing nation's debt can spur big moves on that country's stock market.

While the rating systems of Moody's and S&P differ somewhat, they're more alike than different. Both agencies have investment-grade ratings, which connote a high level of creditworthiness, and speculative ratings, which mean higher risk levels and merit higher interest rates.

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