Credit rating on bonds helps to denote the credit risk associated with a bond. And all such Bonds can be investment-grade or non-investment-grade. High-yield bonds or junk bonds are the other names of non-investment grade bonds. Investment-grade bonds are likely to meet their financial obligations with regard to the timely payment of interest and principal.
Investment Grade Bonds are the ones that carry a lower risk of default and thus, get higher ratings from the credit rating agencies. And the financial strength of such firms usually remains good to excellent. Generally, such bonds offer lower yields than bonds with lower ratings. In simple words, we can say that an investment-grade bond is a classification of bonds denoting that it carries less risk than other bonds.
As higher-rated bonds are low-risk bonds, considering their high demand, the interest yield normally remains lower. Further, the yields vary as per the rating category. Therefore, the rating and yield have an inverse relationship. Hence, the higher the rating on a bond, the lower its yield. So, it means that bonds with investment grades will have a lower yield than junk bonds. Junk bonds offer a higher yield because investors want more return for investing in bonds with higher risk.
The above discussions clearly spell out the importance of rating of bonds. And these ratings assist investors in making proper and informed investment decisions.
For instance, a bond with a rating of AAA will offer a yield of 3% because of low credit risk. In contrast, a bond with a B rating has a yield of 7% because of higher credit risk.
Different credit rating agencies have different rating structures and nomenclature to denote an investment-grade bond. For instance, Standard & Poor and Fitch’s BBB- or higher rating denotes such bonds, while Moody’s rating for such bonds is Baa3 or higher.
Investment Grade Bond Ratings
As said above, different credit rating agencies have varying rating systems for the bonds.
S&P, for example, makes use of capital letters for rating the bonds. This rating agency gives the following ratings: AAA, AA, A, BBB, BB, B up to D. Bonds with AAA and AA ratings are considered to have high credit quality, while A and BBB denote medium credit quality. Both high and medium credit quality bonds are investment grade. On the other hand, bonds with a lower than BBB rating are considered as junk bonds.
Moody uses a mix of capital letters, small letters, and numbers to rank the bonds. The various symbols used by Moody for rating investment-grade bonds are Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3.
A point to note is that several ratings, such as AAA and BB, may denote an investment-grade bond. But, the credit risk of bonds in both these ratings will differ. The bond with an AAA rating will be less risky than BB, but the risk level of both the bonds isn’t enough to categorize them as non-investment grade.
The credit rating agencies don’t have the authority to rate the government bonds or Treasuries. Yet, such bonds are considered to have the highest credit rating as they enjoy sovereign backing.
Investment Grade Bond Rating – Not Permanent
A point to note is that the investment-grade rating that a bond gets is not permanent. This rating may change, which means the bond may get a better investment grade rating or lose its investment-grade rating. While determining the rating for an instrument, the agencies consider many external and internal factors that have a bearing on the final rating for a bond. These factors are economic growth, global economic scenario, regulatory changes, industry-specific issues, financial and liquidity strength of the issuers, the operating and future business growth of the issuer, extent of loans and their payment liabilities, and more.
For instance, if an economy is facing a downturn, it could get hard for companies to meet their financial obligations. This will obviously weaken the strength of the company and thus, in turn, lead to a drop in the rating of its bonds. A point to note is that companies with low ratings are more susceptible to changes in the economic environment. Also, if a company takes on more debt, the rating agencies may slash their rating.
In contrast, when an economy is doing well, there are better chances of a company meeting its financial obligations timely. And, in turn, get a better rating for their bonds.
Advantages and Disadvantages of Investment Grade Bond
The investment-grade bonds have the following advantages:
- The biggest benefit is that it gives investors an idea of the credit risk associated with the bond.
- Such bonds offer less returns but are relatively less risky as well. Thus, they help to diversify the portfolio as they have no co-relation to the equity.
- Such bonds have less default risk, meaning there is less chance for investors to lose their funds.
- In order of credit ratings (AAA to BBB), these are next to the risk-free or government financial instruments.
Investment Grade Bonds do have their disadvantages also. And these are:
- Despite the rating, it is important that investors carry out their own research. This is because it is possible (though extremely rare) for companies to sugarcoat their financials to get a high rating. And sometimes, the rating agencies do fall prey to this jugglery.
- One big drawback of rating is that they are not real-time events. It means that the rating changes only after an event. It is also possible that a rough phase or an adverse event that lasts for a very short time has a long-lasting impact on the company’s creditworthiness. Since the rating changes and review happens at a particular frequency, any such major event in between may risk the investments.
- Having an investment-grade rating is no guarantee that the bonds will have the appropriate demand from the investors.
Investment-grade bonds offer low returns but are less risky as well. This makes them ideal for risk-averse investors or those looking for a stable income along with the safety of their investment. Moreover, these bonds are also suitable for investors looking to diversify their portfolios or lower the overall portfolio risk.
Investors, however, should not just rely on the investment-grade rating for making an investment. They must carry out their own research, as well as ensure that the bond matches their investment requirements.
Also, read – All the 21 Types of Bonds.