How is a credit risk rating assigned to bonds and what does it imply?

• A. Ratings show liquidity
• B. Ratings show inflation adjustment
• C. Ratings indicate default risk; higher risk equals higher yield but greater chance of default
• D. Agencies assign ratings (AAA to junk) indicating default risk; higher risk equals higher yield but greater chance of default

Answer: (D)

Credit risk rating measures the likelihood that the bond issuer will default on payments. Rating agencies like S&P, Moody’s, and Fitch evaluate the issuer’s financial strength and ability to meet obligations, then assign a rating from high-quality (AAA) to below investment grade (junk). This rating signals default risk: the lower the rating, the higher the perceived risk of not paying as promised. Because investors demand compensation for taking on more risk, bonds with lower ratings typically offer higher yields, reflecting the greater chance of default. Ratings focus on creditworthiness, not other factors like liquidity or inflation adjustments, which are influenced by different market dynamics.