Laila Keith
Investment-grade funds are those that are considered to have a lower risk of default and receive higher ratings from credit rating agencies. These agencies, including Moody's, Standard & Poor's, and Fitch, assess the creditworthiness of bonds, with investment-grade bonds receiving a rating of Baa (Moody's) or BBB (S&P and Fitch) or above. These ratings indicate a relatively low risk of default, making them attractive to conservative investors. The higher the grade, the safer the investment, and investments with lower ratings carry a greater risk of default.
| Characteristics | Values |
|---|---|
| Bonds with a lower risk of default | Baa (by Moody's) or BBB (by S&P and Fitch) or above |
| Bonds with higher ratings by credit rating agencies | Baa (by Moody's) or BBB (by S&P and Fitch) or above |
| Bonds with higher yields | Ba1/BB+ and lower |
| Bonds with lower yields | Baa3/BBB- or better |
| Bonds with higher risk | Ba1/BB+ and lower |
| Bonds with lower risk | Baa3/BBB- or better |
| Bonds with higher credit quality | AAA, AA, A, and BBB |
| Bonds with lower credit quality | BB, B, CCC, etc. |
What You'll Learn
Investment-grade bonds are rated Baa3/BBB- or better
Investment-grade bonds are those that carry a low default risk and are, therefore, considered safer investments. The three major bond rating agencies, Moody's, Standard & Poor's, and Fitch Ratings, assess the credit quality of bonds, which helps investors decide whether to invest in them. Bonds with a rating of Baa3/BBB- or better are considered investment-grade.
The bond rating system uses a combination of letters and numbers to indicate a bond's credit quality. The higher the grade, the safer the investment. While the three agencies use different rating systems, they all follow a similar pattern, with AAA or Aaa being the highest rating. Bonds with these ratings are considered to have the highest credit quality and the lowest risk of default.
Bonds rated BBB- or Baa3 and above are considered investment-grade. These ratings indicate medium credit quality and a relatively low risk of default. Bonds with these ratings tend to be issued at lower yields than less creditworthy bonds.
Investment-grade bonds typically pay lower interest rates due to their higher credit quality and lower risk. This means that the probability of receiving the principal back is considered high, so issuers can afford to pay lower interest rates because the risk is low for investors.
It is important to note that bond ratings are not a perfect indicator of an investment's performance. They are based on a company's financial health at a specific time and can change due to financial and economic conditions. Therefore, investors should monitor bond ratings regularly and stay informed about the news and their portfolio.
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Investment-grade bonds are considered low risk
Investment-grade bonds are considered low-risk bonds. They are assigned "AAA" to "BBB-" ratings from Standard & Poor's and Fitch, and "Aaa" to "Baa3" ratings from Moody's. These ratings indicate a low risk of default, with "AAA" and "Aaa" ratings signalling the lowest risk.
The higher a bond's rating, the lower the interest rate it carries, due to the lower risk. Investment-grade bonds are viewed as safer and more stable investments, attracting conservative investors. They are tied to publicly traded corporations and government entities that boast positive outlooks.
The three major credit rating agencies, Standard & Poor's, Moody's, and Fitch, provide ratings on bonds. Each agency has a similar hierarchy to help investors assess a bond's credit quality compared to other bonds. They assess the financial health of each bond issuer and assign ratings to the bonds being offered.
Bonds with a rating of "BBB-" or better on the Standard & Poor's and Fitch scale, or "Baa3" or better on Moody's scale, are considered "investment-grade". Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds.
Historically, investment-grade bonds have had low default rates compared to non-investment-grade bonds. For example, the highest one-year default rate for AAA, AA, A, and BBB-rated bonds (investment-grade) were 0%, 0.38%, 0.39%, and 1.02%, respectively. This can be contrasted with the maximum one-year default rate for BB, B, and CCC/C-rated bonds (non-investment-grade) of 4.22%, 13.84%, and 49.28%, respectively.
As such, institutional investors generally limit their bond investments to investment-grade issues due to their low risk of default.
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Credit rating agencies determine a bond's rating
To determine a bond's rating, these agencies conduct a thorough financial analysis of the bond issuer. They evaluate the financial strength of the issuer, including their ability to pay the bond's principal and interest in a timely manner. This analysis involves assessing the issuer's financial statements, cash flow, debt ratios, profitability measurements, and liquidity measures.
Based on their criteria, analysts from the credit rating agencies determine the issuer's ability to pay their debts and maintain liquidity. They also consider the bond's future expectations and outlook. The agencies then assign a rating to the bond based on the collection of these data points.
It's important to note that different agencies may have varying ratings for the same bond due to differences in their methodologies and criteria. For example, a bond rated "AAA" by S&P and Fitch is considered investment grade, while a rating of "BBB-" or higher is required from these agencies for a bond to be classified as investment grade. Meanwhile, Moody's considers bonds with a rating of "Baa3" or higher as investment grade.
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Investment-grade bonds are issued at lower yields
Credit rating agencies like Standard & Poor's (S&P), Moody's, and Fitch assess the financial health of bond issuers and assign ratings to the bonds they offer. These ratings are based on the issuer's ability to make interest payments and repay the loan in full at maturity. The higher the rating, the lower the risk of default.
Investment-grade bonds are those with ratings of BBB- or higher for S&P and Fitch, and Baa3 or higher for Moody's. These ratings indicate that the bond issuer has a high capacity to repay their loans and a low risk of default. As a result, investors are willing to accept lower yields for these bonds.
On the other hand, non-investment-grade or junk bonds have lower credit ratings, indicating a higher risk of default. To compensate investors for this additional risk, junk bonds are typically issued at higher yields.
The higher yields of junk bonds can be attractive to investors, especially those with a high-risk tolerance and a long investment time horizon. However, investment-grade bonds are generally favoured by conservative investors, income investors, and retirees who seek lower risk and stable returns.
It's important to note that bond ratings can change over time. A downgrade in rating from investment-grade to junk status can have severe repercussions for the issuing company, making it more challenging to source financing options.
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Investors group bond ratings into two categories
Investors group bond ratings into two main categories: investment-grade and non-investment-grade (also referred to as high-yield or junk bonds).
Investment-Grade Bonds
Bonds rated Baa3/Baa or BBB-/BBB- and above are considered investment-grade. These ratings are given by the three main rating agencies: Moody's, Standard & Poor's (S&P), and Fitch. Investment-grade bonds are considered to have a low risk of default and are therefore viewed as safer and more stable investments.
The highest-rated bonds are given the following ratings by each agency:
- Moody's: Aaa
- S&P and Fitch: AAA
Non-Investment-Grade Bonds
Non-investment-grade bonds are those rated below Baa3/BBB-. These are considered high-yield or junk bonds, indicating a higher risk of default. Bonds in this category are more likely to have liquidity issues and may not be able to meet their debt payment obligations.
While investment-grade bonds are considered safer, non-investment-grade bonds can still attract investors due to the high yields they offer.
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Frequently asked questions
An investment-grade fund refers to bonds that are believed to have a lower risk of default and receive higher ratings from credit rating agencies. Bonds rated Baa by Moody's or BBB by S&P and Fitch or above are considered investment-grade.
Investment-grade funds are considered to have a relatively low risk of default, making them attractive investment options for conservative investors. These funds tend to be issued at lower yields than less creditworthy bonds.
The three main credit rating agencies that evaluate the creditworthiness of bonds are Moody's, Standard & Poor's (S&P), and Fitch. They use different designations, such as upper- and lower-case letters ("A" and "B"), to indicate a bond's credit quality rating. Bonds with a rating of BBB- (on the S&P and Fitch scale) or Baa3 (on Moody's) or better are considered investment-grade.
