The possibility of a company or municipal government defaulting on their bond obligations, usually by going bankrupt, is a real one.

For this reason, all bonds are rated according to the financial stability of the issuer. A look at the history of corporate and municipal debt will illuminate the fact that the possibility of the issuer being unable to pay its obligations to bondholders is a very real one. There is an established system of bond ratings that gives a rough estimate of the bond's reliability.

There are three main sources of bond ratings: Standard & Poor’s , Moody's, and Fitch.

S&P has a rating system as follows: AAA is the highest rating, and usually, only the US government and the largest, well-established corporations with large amounts of cash are awarded this rating. Going down the scale, the S&P ratings are as follows: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, etc. Moody’s and Fitch each have their own, but similar, system.

In general, bonds rated below BBB on S&P and Fitch's scales are typically called "junk bonds." These bonds usually carry greater risk but also generate higher returns, so, despite the name, they can be quite good investments. In any case, before you purchase a bond, it is important to understand exactly what you're buying and to make sure your portfolio has the right balance of high and low risk bonds.

Something to keep in mind: rating agencies have come under severe scrutiny in recent years, because, for example, the bonds of Enron were rated AAA just two days before Enron went bankrupt, and the bonds of now default real estate mortgage originators were highly rated on the days of bankruptcy announcements. Similar high ratings existed on AIG before their tumble began in 2008.

Therefore, nowadays, most professional investment managers take these ratings with a sizable grain of salt.

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