A Complete Guide To Investment Grade Bonds And Their Portfolio Role

Investment Grade Bonds & Their Role In An Investment Portfolio

What’s an investment grade bond and what qualities must it have to qualify? There is whole world of bonds out there. Government-issued bonds, bonds issued by blue chip corporations, bonds issued by medium and small-cap public companies and bonds issued by quickly growing start-ups. But only some of the bonds available to investors are considered ‘investment grade’ bonds.

In this article we’ll explain exactly what it is that qualifies a bond as ‘investment grade’ and the role this particular kind of bond plays in an investment portfolio.

What Qualities Does A Bond Need To Qualify As ‘Investment Grade’?

The classification of a bond as ‘investment grade’ is based on the perceived credit worthiness of the issuer. If the issuer of a bond, usually a country or company, has a particularly strong credit rating, which translates into being considered a low credit risk, the bond may be classified as ‘investment grade’. Each bond issue is assigned its own credit rating.

While a bond issuer’s credit rating is not transferred automatically to the bond itself, it is the single most influential factor. How much overall debt the issuer has, including previous bond issues, as a ratio to its revenues, profits and value of assets, will also be considered. Bond ratings are assigned by one of the three major credit ratings agencies – Standard & Poor’s (S&P), Moody’s & Fitch.

All three have their own credit ratings system and a minimum credit rating threshold for a bond to qualify as ‘investment grade’. However, they all use the same basic criteria and in most cases only bonds that are on the threshold might be classified as investment grade by one ratings agency and not by another.

• S&P – classifies bonds as investment grade if assigned a rating of BBB- or higher.
• Moody’s – classifies bonds as investment grade if assigned a rating of Baa3 or higher.
• Fitch – classifies bonds as investment grade if assigned a rating of BBB- or higher.

Credit ratings give investors crucial information on the credit risk a particular bond represents ie. how likely it is that the issuer might default. Standard & Poor’s bond credit rating system is illustrated by table below:

Source: Corporate Finance Institute

S&P’s bond rating system assigns ‘investment grade’ status to bonds that represent either low or moderate default risk. The issuer is considered likely to be in a position to meet payment obligations. Bonds with a credit rating that falls below investment grade are most commonly referred to as junk bonds though they can also be called high-yield or non-investment-grade bonds.

Junk bonds, particularly those that fall just outside of the ‘investment grade’ criteria, are also popular with some kinds of investors. While they represent some risk of default, they also tend to offer higher returns to compensate investors for taking on a higher level of risk. Sensibly invested in as part of a diversified portfolio, higher risk bonds can, by virtue of their stronger returns, help drive overall portfolio performance.

Corporate and Central Bank-Issued Investment Grade Bonds

Investment grade bonds by issued by countries, through their central bank, or by corporations. In both cases, the issuer of the bonds is doing so to raise cash that is usually earmarked to be invested in major capital expenditure. In the case of countries issuing bonds, that could be to fund large infrastructure projects that would be expected to contribute to growing the national economy over the long term, justifying the upfront investment.

Or the funds raised could be injected into the national economy in the form of services or temporary tax cuts or incentives. Borrowing to increase government spending is also done with a view to boosting the economy in a way that it is hoped will also lead to longer term returns that will justify paying the interest rate that bond investors will receive.

Companies also issue corporate bonds to raise cash for major investment projects such as production facilities, R&D or expansion. They are a debt-based alternative to raising cash through the sale of assets or diluting existing shareholders by issuing new equity.

In the case of both corporate and nationally-issued bonds, not all qualify as ‘investment grade’. Only those that a major credit ratings agency assigns a high enough credit rating to.

Default Rates For Bond Issues

As fixed income investments, which means the level of returns, and lifetime of the investment, is fixed at the outset, the only investment risk attached to bonds is either late payment or default. But investors do have to realise that defaults do happen, even if they are extremely rare in the case of investment grade bonds.

S&P Global’s 2018 Annual Global Corporate Default and Rating Transition Study, provides statistics on exactly how often bond defaults occur. As would be expected, the S&P data demonstrates that the default rate on investment grade bonds is significantly lower than that of non-investment-grade junk bonds.

According to the study’s data, a AAA-rated bond has never defaulted – not once. The highest one-year default rate for AA-rated bonds was 0.38%. The highest annual default rate was 0.39% for A-rated bonds and 1.02% for BBB-rated bonds.

Below bonds with investment-grade credit ratings, that leapt considerably to 4.22%, 13.84% and 49.28% for BB, B and CCC/C-rated bonds respectively. It should be kept in mind that those default rates are for the single year with the highest default rates on historical records.

Institutional investors tend to restrict themselves to investment grade bonds due to their historically low record of default. Bond funds can take very different approaches depending on their risk profile. Low risk bond funds will only invest in investment grade bonds but moderate to higher risk funds chasing higher returns will also often allocate a portion of their capital to junk bonds.

The advantage of investing in a bond fund rather than individual bonds, especially when it comes to investing in junk bonds, is that they spread default risk by investing in a range of bonds. That means one or a few defaulting shouldn’t derail long term investment returns as the rest continuing to pay out the agreed ‘coupon’ (fixed interest rate) reduces the overall impact on the fund’s performance.

 Investment-Grade Bond Investment Example

An investor looking for a low to moderate risk bond fund, would be expected to look for a fund that invests the majority of its capital in investment grade bonds. Below is an example of a bond fund’s allocation based on the Standard and Poor’s credit rating system:

Source: Corporate Finance Institute

With 20% of the fund invested in bonds with a AAA rating, 12% in bonds with an AA rating, 21% in A-rated bonds and 9% in bonds with a BBB-rating, a total of 62% is allocated to investment grade bonds. The remaining 38% is split between BB-rated bonds and B-rated bonds, with the latter only attracting a modest 3% of all capital invested.

How Does A Bond’s Credit Rating Effect Its Yield?

The general rule is that the higher a bond’s credit rating, the lower the fixed-income yield it will offer. The best rated investment grade bonds, those issued by countries and companies that have never defaulted and have iron-clad financial stability, usually offer yields that are lower than even the inflation rate.

The lower a bond’s credit rating, and higher the associated risk of default, the better the yield offered to investors to compensate them for taking on more risk.

For example, a 10-year bond rated AAA (investment-grade) may only offer a yield of 2%-3%, or less, due to the extremely low credit risk. But a 10-year bond rated B (non-investment-grade) could offer a yield of 5%-7% due to the higher implied credit risk associated with the bond.

The Role Of Investment Grade Bonds In A Portfolio

As such, investors put money into low yield investment grade bonds not to earn money through returns but to preserve capital. They are used as a tool to protect investment portfolios against stock market downturns. When equities have sustained paper losses, selling them crystalises those losses. If the investor can avoid selling them until the stock market recovers, those losses would normally be expected to be reversed over the months and years to come.

In the meanwhile, if the investor needs to raise cash, they can sell off investment grade bonds, which won’t have lost value. That should mean there is no need to sell other investments at a loss and the investor can sit-out the time until paper losses on equity investments move back into the black.

That’s why when investors either anticipate a stock market downturn, or they edge closer to the moment they plan to take an income from an investment portfolio, they tend to move more capital into the security of investment grade bonds.