Why analyzing a bond only based on its rating is a bad decision

Updated: Sep 6, 2020

Bonds are unattractive for most of investors at the moment. This is commonly known based on the fact that the interest environment is really low and the key interest rates in many developed economies are already at or near zero, sometimes even negative.

I strongly believe that we won't see any higher interest rates in the developed economies in the near future. Monetary keepers and central banks will be very careful with raising chalk rates as slowly as possible so as not to overstrain the economy on its currently very shaky legs.

Interest rates and bond prices interact with each other (reciprocal)

  • scenario 1 = we see rising interest rates - rates on bonds will rise - the bond price will sink

  • scenario 2 = we see sinking interest rates - rates on bonds will sink - the bond price will rise

If you intend to hold the bond until the end of the term, these interest rate risks are of course unimportant, since you will get back your own capital at the end of the term.

However, it is different if you want to trade bonds and sell them again before the end of the term in order to benefit from a price gain.

And if you want to trade bonds like I do it for example, the following knowledge will be important:

Bonds are classified by rating agencies (Moody's, Standard and Poor's, Fitch) for their security of repayment.

Many investors are now looking to only refer to very well rated bonds and do not include any other factors in the decision-making process.

But you should consider also to look for the price at which the bonds are trading currently.

Simply said in my opinion it makes more sense to buy a BBB rated bond for 0,75 or 0,50 pennies a dollar, rather buying an AAA rated bond for 1,25 pennies a dollar.

What I would like to express is that I will never buy a bond only based on its rating given by any rating agency.

The current price level at which the bond is traded must always be included and weighed against other bond alternatives.

For me, this is also the reason why poorly rated bonds can still be more attractive for investors who pursue a corresponding strategy.