By Rick Glaze

The Federal Reserve Bank increased the short-term rate, the Fed funds rate, by a quarter of a percent last week. This move indicates a healthy economy but one that is not too robust. Too much economic activity causes inflation and regular readers should understand what that means. Inflation is a hidden tax that affects low-income consumers even more than high-wage earners. We have a flat yield curve, so short-term bond yields are about the same as long-term bonds right now.

Investors often ask how bonds work and how one chooses good, high-quality bonds for a portfolio designed for both security and income. Several rating agencies have made a business evaluating and ranking bond issuers.

Last fall in this column, I addressed the recent history of state bonds and how public spending pushed the bonds’ rating to near “junk” status. But what does it mean to be a junk bond?

Standard and Poor’s (S&P) and Moody’s Investor Services are two prominent rating agencies. They have similar but not identical ratings. S&P and Moody’s rate the highest quality bonds AAA and Aaa, respectively. Moody’s describes the top rating as “highest quality; carrying smallest degree of investment risk. Interest payments are protected by large or an exceptionally stable margin.”

For many years, banks and trust departments conventionalized the idea that BBB and higher ratings were good enough for prudent investing, and they named the BBB bonds “investment grade” or “bank quality.” Moody’s describes that bond as “good quality, neither highly protected nor poorly secured: may be regarded as somewhat speculative.”

When a bond is initially rated below or falls below this rating, it is often designated a junk bond. S&P describes the BB bond as “questionable; faces major uncertainties. Adverse conditions could jeopardize principal and interest payments.”

Rick Glaze is the president of Glaze Capital Management Inc. of Los Altos. For more information, call 934-0920.