Investment Grade Definition
Investment grade is a rating of fixed-income bonds, bills, and notes by credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s, which signifies a low risk of default. The rating determines the creditworthiness of companies based on their financial strengths and structure, past data, and growth potentials. Companies with good levels of debt, debt repayment, good earning potential, and growth will have good credit ratings.
Investment grades help investors in the decision-making process regarding which bonds to invest in. The credit rating agencies determine the creditworthiness based on many factors like earnings, cash flows, debt repayment ration, price earning ratioPrice Earning RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. , leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity., and other financial ratios.
The bond ratingsBond RatingsBond rating refers to how designated agencies classify fixed income securities in order to help investors identify the security's future potential. After researching the issuer's financial standing, including growth prospects and upcoming corporate actions, ratings are assigned. are not fixed and keep changing. There are a lot of factors due to which the rating could change. For example, economic recessionEconomic RecessionEconomic recession is when economic activity is stagnant, and there is contraction in the business cycle, over-supply of goods compared to its demand, and a higher unemployment rate resulting in lower household savings and lower expense, inflation, higher interest rate and economic crisis due to higher fiscal deficit., financial position, industry-specific problems, economic reforms, global changes, etc. If the economy is going through downtime or companies are in financial distressFinancial DistressFinancial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually the result of high fixed costs, obsolete technology, high debt, improper planning and budgeting, and poor management, and it can eventually lead to insolvency or bankruptcy., then companies will have a problem in meeting its financial obligations, and in such cases, the rating drop. Companies with low ratings are more vulnerable due to changes in the economy, industry, and regulatory.
On the other hand, when the economy is boosting, and there are ample opportunities for growth and expansion, the companies will generate good cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. and reflect a strong financial position, and in such case, the credit ratings will go up as they are in a better position to repay debt and interest.
Investment Grade Ratings
The ratings are classified in the order from best to worst in different patterns by different agencies.
For example – S&P uses capital letters in the order of best rating to the poorest. It follows the pattern of AAA, AA, A, BBB, BB, B up to D. Bonds having high credit quality (AAA and AA) and medium credit quality (A and BBB) are known as investment grade. Bonds having low credit quality rating (BB, B, CCC, etc.) are known as junk bonds or non-investment grade.
Junk bonds will usually yield a higher rate of interest but are at a high risk of default. Different agencies use different variations for credit ratings.
Similarly, Moody’s investment-grade use a mix of the capital letter and small letters.
Example of Investment Grade
As per S&P’s investment-grade rating, the following are few rated bonds in the United States
- Kansas Dev Fin Auth (AAA rated)
- Hopkins Pub Schs (A rated)
- Willis North America Inc. (BBB rated)
- Michaels Stores Inc. (B rated)
As per S&P’s investment-grade rating, below are few rated bonds in the United Kingdom.
- Towd Point Mortgage Funding 2018 – Auburn 12 PLC (AA rated)
- Lloyds Bank Corporate Markets PLC (A rated)
- FCE Bank PLC (BBB rated)
Advantages of Investment Grade
- Credit ratings indicate the risk associated with bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period., bills, and notes. It is helpful for investors to decide if it’s suitable to invest as per their return and risk preference.
- Investment-grade bonds provide low returns but also have a low risk of default. They diversify risk in a portfolio as they are not correlated to equity.
- Investment-grade bonds provide a low risk of default, i.e you are very less likely to lose your money.
- Investors can monitor the change in the credit rating of bonds. For example, if there is a drop from BBB to BB it means the bonds are reclassified to junk bond status. Although the drop is only one level, the impact is severe and the risks vary.
- Investors can sell a good rated bond and gain by selling at a higher price. Similarly, at low times, they can buy bonds when the price declines for which they anticipate a hike in price.
Disadvantages of Investment Grade
- It’s important to research about the bonds in which you are willing to invest. During the 2007-08 recessions, it was seen that false credit rating was given to companies that were at a high risk of default. Rarely now but it’s possible that companies project false cash flows and financial position to get a good rating.
- The rating is not a real-time event. The change in rating usually happens after the occurrence of an event and sometimes the companies may face unforeseen events for a short time which may affect its creditworthiness for a long period of time.
- Chances of finding an investor to purchase your bonds can be difficult when you are in dire need of cash.
Investment-grade bonds are ideal for investors who are risk-averse and are looking for a stable income. It’s also suitable for investors who want to diversify their risk in the portfolio. Such bonds are low-interest rate bonds but also provide low default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.. Investors should vary of few things before they invest. They should vary on how long they are willing to invest in bonds and accordingly select the bonds maturity date. Other factors to be considered are bond terms, payment terms, interest rate calculation (fixed or floating), companies’ financial position, etc.
This has been a guide to what is investment grade and its definition. Here we discuss what is investment-grade bond ratings along with the examples and explanation. You can learn more from the following articles –