Investment Grade: A Type of Bond Explained

Irrespective of the investment type, decision-making entails detailed market research and analysis. Investors use a combination of fundamental and technical analysis to evaluate the investment’s worth. Various research reports, financials, and industry reviews assist in chalking out an investment plan.

Credit ratings are an additional parameter for debt instruments to measure the risk-reward trade-off for the investment. This blog highlights the different credit ratings associated with investment-grade bonds.

What is investment-grade credit rating?

Bonds are financial instruments that pay fixed income at regular intervals for a fixed tenor and repay the principal at the end of the tenor. Bonds may be secured to a specific asset, whereas unsecured bonds rely on the issuer’s creditworthiness and income-generating capacity.

Credit rating agencies evaluate the risk of default associated with bonds and accordingly assign ratings. There are several credit rating agencies worldwide. Globally, Standard & Poor’s, Fitch, and Moody’s are some of the most prestigious credit rating agencies. In India, CRISIL and ICRA are well-known. Each rating agency evaluates numerous financial parameters and assigns a rating to a bond.

Ratings range from AAA to C and D. AAA-rated instruments are the safest, with low default risk. The credit risk associated with D-rated bonds is the highest, or the bond is currently in default. The table below summarises investment grade ratings –

Although the terminology of ratings differs for each rating agency, the level of risk involved is standard. Bonds are of two types: investment-grade bonds and junk bonds based on the assigned ratings.

What are Investment Grade Bonds?

An investment-grade bond refers to bonds with a relatively low risk compared to other bonds, i.e., the credit risk ranges from lowest to moderate levels. Typically, investment grade bonds include bonds with a rating of BBB or higher. 

Companies with reasonable debt levels, good earnings potential, and decent debt-paying history are assigned investment grade ratings. On the contrary, bonds with a lower credit rating, such as BB, B or CCC, are high-risk and low-credit quality bonds commonly referred to as junk bonds. Investment in junk bonds is highly speculative.

Government securities, treasury bills, and commercial paper are AAA+ rated since the default risk associated with such securities is minimal. Investment-grade investments include debt instruments such as bonds, debentures, and corporate deposits of established, blue-chip companies.

In 2018, S&P Global conducted an Annual Global Corporate Default and Rating Transition Study to assess default rates for different classes of bond ratings. The highest one-year default rate for investment grade bonds was less than 1%, whereas for CCC/C- rated bonds, it was up to 49.28%. Hence, institutional investors prefer dealing in these bonds due to low default rates.

Characteristics of Investment Grade Bonds

Investment grade bonds provide excellent opportunities to earn returns with a minimum risk of default. Here are some of its key characteristics:

• Credit ratings: These bonds are backed by credit rating agencies (S&P, Moody’s, Fitch). These ratings range from AAA (Highest Safe) to BBB (Moderate Safe).
• Face Value: The face value of a bond refers to the price of a single unit of a bond issued by the company in the primary market. It is also known as a bond’s principal, nominal or par value.
• Tenure: The tenure of investment-grade bonds varies from a few months to several months.

Investment Grade Credit Rating Details

Understanding investment grade ratings in India is significant since it suggests the risk associated with the investment. Credit rating agencies evaluate the issuer’s creditworthiness and the leverage, cash flow, earnings, and financial ratios of the issuer.

Bond investment grades are subject to review and change. Credit rating agencies may reduce a bond’s rating if the issuer faces financial problems. A downgrade may be caused by things such as recession, issues affecting the industry that the company is in or reduced cash flow. 

Furthermore, emerging technology or competition may impede the future earning capacity of the company. For example, Most of the previously highly AAA-rated companies and investments were lowered during the 2008 financial crisis.

While an investment downgrade of bonds from BBB to BB is merely a one-step drop, the repercussions are severe. The instrument moves from investment grade to junk and indicates that the company may struggle with its debt obligations. In turn, it impacts the cost of borrowing and the issuer’s profitability. 

Implications of Credit Rating on Bond Yields

Bond yield refers to the return earned from the bond. For an issuer, bond yield is the cost of borrowing. Credit ratings have a direct impact on bond yields. However, a higher bond rating fetches a lower bond yield. The risk involved with a highly rated bond is relatively low, so the returns from the bond are limited. Similarly, junk bonds are speculative and highly risky; therefore, the bond yield is high.

For example, a 10-year AAA-rated government bond may have a bond yield of 3%, but a 5-year BB- corporate bond returns 7%.

Consequently, the bond investment grade affects the cost of capital and the revenue-generating capacity of the issuer. A rating downgrade can increase the borrowing cost and reduce future cash flows of the issuer.

Bottom Line

Bond ratings signify the level of risk associated with a debt instrument. However, investors must also evaluate the issuer’s financial performance along with its top management, industry, and other macroeconomic factors before investing.