What is a Triple-A (AAA) Bond Rating?
What you need to know about the highest quality bonds.
Once you build your investment capital and begin investing in bonds, you are likely to hear about bond credit ratings, specifically Triple-A bonds, or AAA bonds. This designation might seem confusing but it really comes down to understanding how "safe" a bond is by looking at all sorts of metrics, such as the strength of the issuer's balance sheet, the likelihood of sufficient earnings and cash flows to cover the promised interest and principal repayments, and the collateral that can be seized in the event the bond defaults prior to or at bond maturity.
Understanding the Triple-A Bond Rating
Most bonds receive a grade based on how safe they are as an investment. Triple-A bonds, or AAA bonds, are those considered the absolute safest by bond rating agencies (Fitch, Moody's and Standard & Poor's), while grades can go as low as D. By granting AAA rating, the bond rating agencies are signaling that they think default is all but unthinkable except in the most remote of circumstances. In other words, they believe there is a very low chance you won't get your money back on the investment.
It is extraordinarily difficult to achieve an AAA rating. As has been widely reported in the business press, the 2008-2009 crash was so bad that by the end of the period, there were only four S&P 500 components that could boast an AAA rating. These were:
- Automatic Data Processing, a payroll processing giant that helps other businesses handle their employee withholding and tax paperwork
- Johnson & Johnson, a medical, pharmaceutical, and consumer staples giant that owns 265 individual operating companies and has a complex history
- Microsoft, one of the world's largest software companies known for its extreme financial conservatism
- ExxonMobil, the old Standard Oil of New Jersey/Standard Oil of New York titan that represents the main descendant of John D. Rockefeller's empire
Triple-A bonds are part of a broader category of bonds known as investment grade. Any bond that is rated BBB- or above is considered investment grade. This has important regulatory implications. For example, a bank trust department or pension fund is going to disproportionately favor investment grade bonds, including Triple-A bonds, as part of the fiduciary duty owed to clients.
Bonds with an AAA rating are considered just below those of sovereign bonds issued by well-run governments, the latter only superior for the fact they possess the authority to tax and have standing armies that can guarantee the repayment of obligations.
Due to their rock-solid status, AAA-rated bonds offer the lowest yields. What you gain in peace of mind you lose in income because other investors are willing to bid up the bond price, especially when things go south (this is known as a "flight to safety").
The Opposite of a Triple-A Bond Rating
With AAA rated bonds at the top of the investment grade class, D rated bonds are at the bottom. A rating of D indicates the bond has already gone into default. D rated bonds are part of a category known as junk bonds.
Average investors would do well to stick entirely to investment grade bonds. As you go down the bond rating ladder, default probabilities rise substantially. Reaching for yield has cost a lot of families a lot of lost wealth. Often, the higher interest rate is an illusion that is taken away when the bond stops sending you interest altogether or you find yourself getting a bankruptcy notification.