Investment Grade Bond: The Basics

Investment grade bonds are bonds whose creditworthiness earns them high ratings by the investment ratings agencies, the two primary agencies being Standard & Poor’s and Moody’s. To be investment grade, a bond must be rated of BBB- or higher by Standard & Poor’s or Baa3 or higher by Moody’s. The highest ratings for investment grade bonds are AAA by Standard & Poor’s and Aaa by Moody’s.

Just What Is a Bond?

In simple terms, a bond is a promise by a bond issuer to repay the amount of money for which the bond is sold. The proceeds of a bond sale are treated as debt by the issuer. You can contrast this with stocks, which are considered equity. Companies, institutions or governments use bonds as a form of debt when they have borrowing needs of longer than a year.

The Importance of Investment Grade

Investment grade bonds are considered reliably certain to be repaid. Financial institutions and parties holding fiduciary responsibilities can legally invest in bonds only if they are investment grade. Because corporations use bonds as one method of raising funds, bond issuers will strive for the highest ratings they can get. And, clearly, for a similar reason, the objectivity and trustworthiness of the ratings agencies is paramount.

Investment Grade versus Government Bonds

Even the highest-rated investment grade bonds are considered riskier than government-issued bonds. If you take the rates on an investment grade bond and on a government bond, the difference—or spread—between them is considered a measure of the economy’s general stability. The lower the spread, the more stable the market views the economy to be.

Investment Grade versus High-Yield or Junk Bonds

Junk bond is another name for a speculative yield, or high-yield, bond. The flip side of the potential for a high yield is greater risk. These bonds are rated lower than investment grade bonds due to their risky nature.

Understanding the Risks

Every investment has risks. With bonds, there is risk because the value of a bond moves inversely with interest rates. The higher the interest rate, the lower the value of the bond. The lower the interest rate, the higher the value of the bond. This can affect the monthly payment most bonds offer. In other words, it can negatively affect a feature most investors value.

Bonds also often are offered with a long date to maturity. Twenty years is not uncommon. That means that there is a much longer time during which the market can affect the bond and the bond issuer. Typically, the longer the date to maturity of a bond, the greater the risk.

It is important to pay attention to the ratings when considering bonds. You can know at a glance how experts have weighed the risk of the investment.

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