Credit ratings are one of the important measures for bond investors since these ratings are assessments of the creditworthiness of a borrower, such as a corporation, government, or a specific financial instrument like a bond. These ratings are assigned by privately owned credit rating agencies such as S&P Global, Moody’s, Fitch Ratings, or Scope. They indicate the likelihood that the issuer will meet its debt obligations (interest and principal payments) in full and on time. As a result, credit ratings help investors evaluate default risk, guide interest rates, and influence borrowing costs for bond issuers.
More generally speaking, ratings range from high-quality (AAA, AA) to lower-quality or speculative grades (BB and below). The ratings may include modifiers (e.g., “A+” or “A-”) to indicate relative standing within a category.
With regard to their rating, bonds are in general classified as investment grade or non-investment grade (high yield) bonds.
Investment grade bonds are bonds which are rated BBB- (S&P, Fitch) or Baa3 (Moody’s) or better. These bonds have a lower risk of default and a stable and predictable income. As a result of their lower default risk, investment grade bonds pay lower yields compared to high yield bonds. Investment grade bonds are in general preferred by investors with a low risk bearing capacity or by investors and institutions seeking steady, low risk returns.
High yield bonds are bonds rated below BBB- (S&P, Fitch) or Baa3 (Moody’s). These bonds have a higher risk of default due to issuer’s weaker financial stability and have to pay higher yields to compensate the investors for the increased risk. The difference between the yield of a high yield bond and a comparable investment grade bond is called “spread.”
Given their higher risk profile, high yield bonds are often used by investors who are seeking higher returns. Since high yield bonds have a different risk/return profile compared to investment grade bonds, they are also used as admixture to enhance the returns and/or diversification of investment grade bond portfolios.
That said, investors need to double check whether the strategy of a bond portfolio fits with their overall strategic or tactical asset allocation and their risk bearing capacity/risk tolerance.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
