How do credit ratings influence bond selection?

• A. Higher-rated bonds always have higher yields.
• B. Higher-rated bonds have lower safety.
• C. Higher-rated bonds are generally safer but offer lower yields.
• D. Ratings have no impact on risk or yield.

Answer: (C)

Credit ratings signal default risk and shape the return investors require. Higher-rated bonds are seen as safer because the issuer is more likely to meet its debt obligations, so the perceived default probability is lower. With lower risk, investors demand a smaller risk premium, which pushes yields down for these bonds. In contrast, lower-rated bonds carry higher default risk, so investors demand higher yields to compensate, lifting the yield relative to safer issues. This creates the general pattern: safer bonds tend to offer lower yields, while riskier bonds offer higher yields. Ratings do affect both risk assessment and the required return, and the notion that higher-rated bonds pay more or that ratings don’t matter doesn’t align with how risk is priced in the market.