Investment Grade

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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 potential. Companies with good levels of debt, debt repayment, good earning potential, and growth will have good credit ratings.

Investment Grade

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Investment grades help investors in the decision-making process regarding which bonds to invest in. Credit rating agencies determine creditworthiness based on many factors like earnings, cash flows, debt repayment ratio, 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. read more, 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.read more, 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.read more 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 defined as the phase in which economic activities of a country become stagnant, leading to a disturbance in the business cycle and affecting the overall demand-supply balance. read more, 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.read more. Companies will have a problem meeting their financial obligations, and in such cases, the rating drop. Companies with low ratings are more vulnerable due to economic and industry changes and regulations.

On the other hand, when the economy is boosting and 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. read more and reflect a strong financial position. In such cases, the credit ratings will increase as they are better able to repay debt and interest.

Key Takeaways

  • Investment grade is a credit rating assigned by organizations like S&P, Fitch, and Moody’s to fixed-income bonds, indicating a low risk of default. Based on historical data and future growth potential, this rating assesses a company’s creditworthiness.
  • Companies with strong debt management, consistent debt payments, high earnings potential, and growth prospects tend to receive good credit ratings. Investment-grade rated bonds are an excellent choice for stable income seekers.
  • These bonds offer minimal default risk and lower interest rates. Investors should align the bond’s maturity date with their desired investment horizon.

Investment Grade Ratings

Different agencies classify the ratings from best to worst in different patterns.

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, and B up to D. Bonds having high credit quality (AAA and AA) and medium credit quality (A and BBB) are known as investment grades. Bonds having low credit quality ratings (BB, B, CCC, etc.) are known as junk bonds or non-investment grades.

Junk bonds usually yield a higher interest rate but are at a high risk of default. Different agencies use different variations for credit ratings.

Similarly, Moody’s investment-grade uses a mix of capital letters and small letters.

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Example of Investment Grade

As per S&P’s investment-grade rating, the following are a 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 a 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

  1. 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.read more, bills, and notes. It is helpful for investors to decide if it’s suitable to invest as per their return and risk preference.
  2. 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.
  3. Investment-grade bonds provide a low risk of default, i.e you are very less likely to lose your money.
  4. 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.
  5. 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

  1. It’s important to research the bonds you are willing to invest in. 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 may companies project false cash flows and financial position to get a good rating.
  2. The rating is not a real-time event. The change in rating usually happens after an event, and sometimes the companies may face unforeseen events for a short time which may affect their creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more for a long period.
  3. Chances of finding an investor to purchase your bonds can be difficult when you are in dire need of cash.

Conclusion

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.read more. Investors should vary a few things before they invest. They should vary on how long they are willing to invest in bonds and accordingly select the bond’s maturity date. Other factors to be considered are bond terms, payment terms, interest rate calculation (fixed or floating), companies’ financial position, etc.

Frequently Asked Questions (FAQs)

1. What is the importance of investment grade? 

Investment grade refers to the credit rating assigned to bonds or debt instruments that are considered relatively safe and low-risk by credit rating agencies. The importance of investment grade lies in attracting a wider pool of investors, including institutional funds and conservative investors, and enabling issuers to borrow funds at lower interest rates.

2. What are the applications of investment grade? 

Investment grade bonds are widely used by governments, corporations, and other entities to raise capital in the debt markets. They are often included in pension funds, retirement accounts, and other investment portfolios seeking stable income and lower risk than higher-yield or speculative-grade bonds.

3. What is an investment grade loan? 

An investment grade loan, often called a “senior loan” or “syndicated loan,” is a type of loan provided by a group of banks or financial institutions to a borrower with a high credit rating. Well-established corporations or governments typically use these loans to finance projects, acquisitions, or other initiatives. The investment grade rating of the borrower helps ensure favorable loan terms and lower interest rates.

This has been a guide to what investment grade is and its definition. Here we discuss investment-grade bond ratings along with examples and explanations. You can learn more from the following articles –