Investment Grade

What Is Investment Grade?

An investment grade is a rating that signifies that a municipal or corporate bond presents a relatively low risk of default.

Understanding Investment Grade

Bond rating firms like Standard & Poor’s and Moody's use different designations, consisting of the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating. "AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."

Credit ratings are extremely important because they convey the risk associated with buying a certain bond. An investment-grade credit rating indicates a low risk of a credit default, making it an attractive investment vehicle — especially to conservative investors.

Investors should note that government bonds, also known as Treasuries, are not subject to credit quality ratings, yet these securities are nevertheless considered to be of the very highest credit quality.

Investment Grade Credit Rating Details

In the case of municipal and corporate bond funds, a fund company's literature, such as its fund prospectus and independent investment research reports, will report an "average credit quality" for the fund's portfolio as a whole.

Investment-grade issuer credit ratings are those rated above BBB- or Baa. The exact ratings depend on the credit rating agency. For Standard & Poor's, investment-grade credit ratings include:

Companies with any credit rating in this category boast a high capacity to repay their loans; however, those awarded an AAA rating stand at the top of the heap and are deemed to have the highest capacity of all, to repay loans.

Many institutional investors have instituted a rigid policy of limiting their bond investments solely to investment-grade issues.

The next category down includes the following ratings:

Companies with these ratings are considered to be stable entities with robust capacities for repaying their financial commitments. However, such companies may encounter challenges during deteriorating economic conditions.

The bottom tier of investment-grade credit ratings delivered by Standard and Poor's include:

Companies with these ratings are widely considered to be "speculative grade" and are even more vulnerable to changing economic conditions than the prior group. Nevertheless, these companies largely demonstrate the ability to meet their debt payment obligations.

According to Moody's, investment-grade bonds comprise the following credit ratings:

The highest-rated Aaa bonds possess the least credit risk of a company's potential failure to repay loans. By contrast, the mid-tier Baa-rated companies may still have speculative elements, presenting high credit risk — especially those companies that paid debt with expected future cash flows, that failed to materialize as projected. 

Credit Downgrades

Investors should be aware that an agency downgrade of a company's bonds from "BBB" to "BB" reclassifies its debt from investment grade to "junk" status. Although this is merely a one-step drop in credit rating, the repercussions can be severe.

The drop to junk status telegraphs that a company may struggle to pay its debts. The downgraded status can make it even more difficult for companies to source financing options, causing a downward spiral, as costs of capital increase.

What Are S&P Investment Grade Rating Tiers?

Basically, credit rating tiers reveal a company's capacity to repay loans. According to Standard & Poor's investment-grade credit ratings, companies awarded an AAA rating are deemed to have the highest capacity of all to repay loans. This is followed by AA+, AA, and AA-, all of which boast a high capacity to repay their loans. The next category includes A+, A, and A-. These companies have robust capacities for repaying loans, but may encounter challenges during deteriorating economic conditions. The bottom tier is comprised of BBB+, BBB, and BBB-. These are widely considered to be "speculative grade" and are even more vulnerable to changing economic conditions, but demonstrate the ability to meet their debt payment obligations.

What Is a Junk Bond?

A junk bond is debt that has been given a credit rating below investment grade. As a result, these bonds are riskier since chances that the issuer will default or experience a credit event, because of an uncertain revenue stream or a lack of sufficient collateral, are higher. Because of the higher risk, investors are compensated with higher interest rates, which is why junk bonds are also called high-yield bonds.

What Is a Downgrade?

A downgrade is a negative change in the rating of a security. This situation occurs when analysts feel that the future prospects for the security have weakened from the original recommendation, usually due to a material and fundamental change in the company's operations, future outlook, or industry. Downgrade increases a company's cost of capital and often results in an immediate hit to the security's price.