No matter what type of investment you choose, the decision-making process requires thorough market research and analysis. Investors combine fundamental and technical analyses to determine the value of an investment. Research reports, financials and industry reviews help to formulate an investment strategy

Credit ratings are a way to assess the trade-off between risk and reward for an investment. This blog discusses the different investment-grade ratings, and the bonds which fall under the investment-grade bond category.

What is an investment grade credit rating?

Bonds, are financial instruments which pay a fixed income on a regular basis for a set period of time and return the principal at its end. Bonds can be secured by a specific asset. Unsecured bonds are based on the creditworthiness of the issuer and their ability to generate income.

Rating agencies assess the risks of bond default and assign ratings accordingly. Credit rating agencies are available in many countries. Standard & Poor’s, Fitch and Moody are among the most prestigious rating agencies in the world. CRISIL, and ICRA are both well-known in India. Each rating agency evaluates financial parameters to assign a rating.

The ratings range from AAA up to C and D. AAA rated bonds have the lowest default risk. D-rated bonds have the highest credit risk, or are currently in default.

Below is a table that summarizes the investment grade ratings.

The level of risk is the same regardless of the rating agencies. According to the ratings, bonds are divided into two categories – investment-grade and junk bonds.

Investment Grade Bonds

Investment-grade bonds are bonds that have a low default rate compared to others, i.e. the credit risk is between lowest and moderate. Investment-grade bonds are typically bonds that have a BBB rating or higher. Investment-grade ratings are given to companies with low debt, good earning potential, and a decent history of debt repayment.

Bonds with lower credit ratings, such as B, CCC or BB, have a low credit quality and are considered high-risk. They are commonly called junk bonds. Junk bonds are highly speculative.

AAA+ is the rating of government securities, Treasury bills and Commercial Paper, as they have a minimal default risk. Investment-grade investments are debt instruments, such as corporate deposits, bonds, debentures and treasury bills, of blue-chip, established companies.

S&P Global published an Annual Global Corporate Default Study in 2018 to evaluate default rates across different bond rating classes. For investment-grade bonds, the highest default rate in a year was less than 1 percent. However, for CCC/C+ rated bonds it could reach 49.28%. Due to the low default rate, institutional investors prefer investing in investment-grade debt.

Investment Grade Credit Rating Details

Investment-grade bonds can be important because they indicate the level of risk involved in the investment. Credit rating agencies assess the creditworthiness of an issuer, as well as their leverage, cash flow and earnings ratios, and financial ratios.

The investment grade of bonds is subject to change and review. Rating agencies can downgrade bonds if the financial health of an issuer changes. Cash flow can be affected by a recession, specific industry hurdles and other factors. The issuer’s earning potential can also be affected by technological advancements or the appearance of a competitor. During the 2008 financial crisis, credit rating agencies degraded many AAA-rated securities and companies.

The consequences of a downgrade from BBB bonds to BB are serious, even though it is only a small step. The instrument goes from investment grade into junk, and it indicates that a company might have trouble meeting its debt obligations. It also impacts the issuer’s profitability and costs of borrowing.

The impact of credit rating on bond yields

Bond yield is the return on the bond. Bond yield is the cost to borrow for an issuer. Credit ratings directly impact bond yields. A higher bond rating will result in a lower yield. A highly rated bond has a relatively low risk, which limits the return. Junk bonds are also speculative, high-risk, and therefore have a high yield.

A 10-year AAA government bond might have a yield of 3% but a 5-year BB+ corporate bond will return 7%.

The bond investment grade has a direct impact on the capital cost and revenue generation capacity of an issuer. Rating downgrades can increase borrowing costs and reduce the future cash flow of an issuer.

Bottom Line

Ratings of bonds indicate the risk level associated with debt instruments. Investors must evaluate the financial performance of an issuer, as well as its top management, sector, and other macroeconomic variables, before investing.