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Credit quality is a term used to describe the assessment of the investment quality associated with a particular bond issue or bond mutual fund. Sometimes referred to as bond rating, the purpose of determining credit quality is to makes sure that the underwriter of the bond issue has an acceptable credit rating, and that the risk of default is within reasonable limits in comparison to the anticipated return. There are a number of rating agencies around the world that undertake a credit analysis of bond issues, including junk bonds, and assign a rating based on their findings.
While rating systems used to assess credit quality vary somewhat around the world, most use a simple system that confers a rating somewhere between excellent and poor. For example, a bond issue that is considered to offer an reasonable return, and is issued by an entity with excellent credit and a low default risk may have a rating of AAA to AA. Bonds that have an assessed credit quality indicating that the bond offers a decent return for the degree of risk involved may receive what is called a medium rate, usually A to BBB. Should the rating agency determine that the anticipated return is not in sync with the risk associated with the bond issue, the rating will likely be anywhere from BB to C.
Investors can make use of credit quality to determine if a particular investment is a good fit for their financial goals. Conservative investors will likely want to focus their attention on bond mutual funds and bond issues that have high rating, or at least a medium rating that is at the higher end of the spectrum. While the return is likely to be less spectacular, the investor is taking on a low amount of risk and can be reasonably sure of earning the projected return.
With investors who are willing to take more chances, evaluating the credit quality will make it possible to identify bond issues that do have a higher degree of risk, but also offer higher rates of return. As with any type of investment that carries greater risk, the investor will want to look closely at what is expected to happen in the market and with the profitability of the issuer over the life of the bond issue. Assuming that theses higher-risk bonds will mature in a relatively short period of time, and the investor does not foresee any shifts in the marketplace that would cause the issuer to default, choosing to invest in a few bonds that have a low rating may lead to significant growth in the investment portfolio.