What Is a Triple-A (AAA) Bond Rating?

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DEFINITION

A Triple-A (AAA) bond rating is the highest rating that bond agencies award to an investment that is considered to have a low risk of default, thereby making it the most creditworthy.

Definition and Example of a Triple-A (AAA) Bond Rating

A bond is a debt instrument, similar to a loan. An entity issues a bond, which an investor buys with the expectation of being paid back in the future, plus interest. Bond rating agencies determine the rating of each bond.

AAA bonds are considered the absolute safest by the three primary bond rating agencies: Fitch, Moody's, and Standard & Poor's. Grades go as low as "D" for Fitch and Standard & Poor's. The lowest rating Moody's grants is "C."

It is extraordinarily difficult to achieve an AAA rating. U.S. companies that have maintained their AAA ratings include Johnson & Johnson and Microsoft Corporation.

By granting the AAA rating, bond rating agencies signal that they have as much faith as possible in these entities to honor the terms of the bonds. In other words, they believe there is a very high chance that you will get your money back.

How Triple-A (AAA) Bond Ratings Work

Bond rating agencies look at many different metrics to determine how safe a bond is as an investment. These include 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 available to seize in the event that the bond defaults before or at its maturity date.

Bond ratings are not permanent, and they may change due to circumstances with the issuer. For instance, the global credit crisis of 2008 caused companies such as General Electric (GE) and Berkshire Hathaway to lose their AAA ratings.

What It Means for Individual Investors

With lower risk come fewer rewards. Due to their low risk and rock-solid status, AAA-rated bonds offer the lowest yields. What you gain in peace of mind, you lose in income.

On the other end of the spectrum are junk bonds, which have low ratings and high yields. They're also known as "high-yield bonds." The companies that issue these kinds of bonds get poor ratings because credit agencies determine they are in danger of defaulting (or have defaulted in the past).

Individual investors looking to invest in bonds will need to choose the level of risk and return they're comfortable with, knowing that if they choose AAA-rated bonds their investment will be safer but deliver a lower return than if they choose lower-rated bonds.

Alternatives to Triple-A (AAA) Bonds

AAA bonds belong to a broader category of bonds known as "investment-grade" bonds. Investment-grade bonds include any bond that is rated at or above BBB- (on the S&P and Fitch scale) or Baa3 (on the Moody's scale). This has important regulatory implications. For example, a bank trust department or pension fund may favor investment-grade bonds over lower-grade bonds because of the strong desire to maintain a steady balance.

The grading system can break down slightly when comparing investment-grade corporate bonds to government bonds like Treasury Bills and Treasury Notes—also known as "Treasurys." Even though a company like Microsoft may be able to issue AAA bonds, U.S. Treasuries are generally considered the safest bonds. That's because they carry the full weight of the U.S. government behind them.

Not all government bonds are as safe as Treasurys. Municipal bonds ("munis") are issued by lower-level government bodies. They can be issued by state authorities, cities, or local agencies such as school districts.

Municipal bonds can also be issued by U.S. territories such as Puerto Rico. Since these bonds aren't issued by the federal government, they don't have federal backing. The relative safety of municipal bond investments varies by the entities issuing them.

Key Takeaways

  • Triple-A (AAA) rated bonds are deemed least likely to default.
  • In return for this safety, the bonds return the lowest interest rate.
  • Bond rating agencies take into account a company's balance sheet and many other factors.
  • Treasury bonds are historically considered the safest bonds.

Article Sources

  1. S&P Global. "Fitch Affirms J&J's Ratings on Consistent Operating, Financial Performance."

  2. Securities and Exchange Commission. "Form 10-K: Microsoft Corporation."

  3. Insurance Journal. "Fitch Lowers Berkshire Hathaway’s ‘AAA’ Rating to ‘AA+’."

  4. Office of Investor Education and Advocacy. "What Are High-Yield Corporate Bonds?"

  5. Fidelity Investments. "Bond Ratings."