Things to Know About Investment-grade Bonds
In today’s world, investment is an integral part of our lives. Working hard isn’t good enough and making one’s money work equally hard is more essential to build a handsome corpus over time.
Stocks, mutual funds, bonds, precious metals, commodities, REIT, and bank savings schemes, among many others, are some investment options available to a retail investor today. And all of them come with the same motive to multiply your wealth.
Acknowledged by many as a safe and sound investment option, bonds are another kind of investment instrument accessible to investors. It may not hold the popularity of stocks, but it is one of the best available investment options when it comes to fixed income groups.
What is a bond?
Typically, a loan agreement between the bond issuer and the investors, bonds are generally issued by corporate houses and state, local, central, or national government bodies. Commonly, referred to as fixed-income securities, bonds are debt instruments issued in the market to raise capital or funding.Unlike stockholders, bond investors don’t have any ownership of the company. However, bondholders are entitled to an annual fixed income at a pre-decided rate and to get the principal back at the end of the maturity period.
Here are a few different types of bonds.
Corporate bonds: Bonds issued by public or private corporations.
Investment-grade bonds: Bonds that are being rated by credible rating agencies, generally issued by only private entities.
High-yield bonds: Generally issued by private entities looking to finance their merger or acquisition activities. These bonds are expected to provide a high yield but have a low credit rating and high credit risk.
Municipal bonds: Often referred to as ‘Muni bonds’, these bonds are issued by government entities belonging to either a state, city, municipality, country or by all of them. These bonds are generally issued to finance government projects,capital expenditures or special projects.
T-bonds: Treasury bonds or T-bonds, principally considered to be risk-free, are bonds issued by the U.S. Treasury Department on behalf of the federal government. T-bonds are generally not subject to credit quality ratings.
What are investment-grade bonds?
Investment-grade bonds have all the essential characteristic of a corporate bond or a municipal bond. But additionally, these bonds come with a trustworthy credit rating from reputed rating agencies. Investment-grade bonds are considered to carry low credit or default risk as compared to other kinds of bonds.
What does investment grade means?
Investment-grade here refers to the rating provided by reputed and credible rating agencies, confirming the quality of the debt issued by the company or a municipal body. The rating issued to the company is generally associated with the debt instruments issued by the company.
These ratings are decided by the agencies based on several factors. Here are a few of them:
- Financial strength of the company based on its financial statements
- Debt repayment capacity of the company
- The quantum of debt obligation already present in the books of the company
- The company’s debt repayment history
- The historical record of profitable growth achieved by the company
- The future growth potential
Generally, companies with a low to moderate debt to equity ratio, good debt repayment history, a track record of profitable growth and high-grade earning potential, tend to have a good credit rating.
For the bond issuer, a favorable credit rating provided by any one or all of the independent rating agencies goes a long way in raising capital or funds from the market. Citing the credit rating, the issuer can establish their creditworthiness and the credit quality of the bonds issued. With a high credit rating, the issuer can also borrow funds at a relatively lower interest cost.
For the investor, the ratings provide a reliable screening platform to evaluate and compare the credit risk of one bond with other bonds or financial instruments available in the market. Using this rating, one can take an informed judgment on whether to invest in the bond.
The top three reputed, reliable, and independent rating agencies, who provide ratings on bonds, are Standard & Poor’s, Moody’s Corporation, and Fitch Ratings. Each of these agencies has different bond rating symbols to indicate investment-grade bonds. A bond is an investment-grade only when it lies above the minimum bond rank issued by these agencies.
Standard & Poor’s classify bonds with a rating of BBB or higher as investment-grade bonds. Moody’s Corporation classifies bonds with a rating of Baa3 or higher as investment-grade bonds. And lastly, Fitch Ratings classifies bonds with a rating of BBB- or higher as investment-grade bonds.
Here is a list of investment-grade ranks and their risk definition.
|AAA, Aaa||Lowest level of credit risk||Investment-grade|
|AA+, AA, AA-, Aa1, Aa2, Aa3||Very low credit risk|
|A+, A, A-, A1, A2, A3||Low credit risk|
|BBB+, BBB, BBB-, Baa1, Baa2, Baa3||Modest credit risk|
|BB+, BB, BB-||Substantial credit risk||Non-investment grade and junk|
|B+, B, B-||High credit risk|
|CCC+, CCC, CCC-||Very high credit risk|
|C||Highest level of credit risk|
What impact does bond rating have on the bond yields?
Investment-grade bonds are generally considered to be safe investment avenues for retail investors by experts. But sadly, bond rating and bond yields have an inverse relationship. Therefore, investment-grade bonds generally provide for a lower yield as compared to non-investment grade bonds. Simply because of the risk-return tradeoff principle,the higher the risk the greater is the return.
How is the investment-grade rating helpful to an investor?
Investing in a bond is nothing but lending money in lieu of interest. While lending money to someone, it is essential to have a detailed understanding of the creditworthiness of the borrower, in this case, the bond issuer. Therefore, an investment-grade rating helps you to gauge the creditworthiness of the bond issuer.
For instance, this is how Standard & Poor defines its different investment-grade ratings:
A rating of ‘AAA’ indicates an ‘extremely strong capacity to meet financial commitments’. ‘AA’ denotes a ‘very strong capacity to meet financial commitments’, while ‘A’ indicates a ‘strong capacity to meet financial commitments’ while also being ‘susceptible to economic conditions.’ Lastly, ‘BBB’ denotes an ‘adequate capacity to meet financial commitments with subject to economic conditions’.
A strong rating is generally considered an indication of the strong and stable financial condition of the bond issuer.
To sum it up
Almost all the financial instruments that are available in the market have some bit of risk associated with them. As an investor, it is better to understand the risk and reward associated with each of them. In search of a little extra reward, if the entire invested corpus gets wasted, then it isn’t a wise investment decision. Investment-grade bonds may notbring exceptional returns, but it ensures that you get back your principal along with some additional rewards.
If you wish to know more about investing in different investment-grade bonds, get in touch with financial advisors.