Final answer:
Bond ratings primarily evaluate the default risk of a bond, affecting the bond's rate of return, which is comprised of compensation for delayed consumption, adjustment for inflation, and a risk premium. High-yield or 'junk' bonds carry higher returns but greater risk. Rising interest rates can make fixed-rate bonds less attractive.
Step-by-step explanation:
Bond ratings classify bonds primarily based on the default risk of the borrower rather than interest rate or inflation rate directly. These ratings assess the likelihood that the borrower will be unable to make the promised payments on the bond. An investor who buys a bond expects to receive a rate of return, with the understanding that bonds vary in rates of return depending on the borrower's riskiness. The interest rate offered by a bond can be dissected into three components: compensation for delaying consumption, an adjustment for an inflationary rise in prices, and a risk premium accounting for the borrower's creditworthiness. High-yield or 'junk' bonds offer higher returns but come with a greater chance of default. This risk is inherent in the bond yield, the promised rate of return at the time of purchase. Bonds carry risk also because they can become less attractive if interest rates increase, causing a bond with a lower fixed interest rate to suffer in value.