An investment grade bond is a bond that meets or exceeds minimum investment risk levels established by a private risk-rating agency.
One way to establish the risk of a bond investment is to rely solely on the market’s price determination.
A bond deemed lower risk by investors will pay a lower rate of interest, or yield. Likewise, a bond that investors consider higher risk will have a lower price but pay a higher yield.
Nevertheless, institutional investors typically demand more information before investing. As a result, private bond ratings agencies issue letter grades to bond offerings that describe the risk of a bond before it is sold.
An investment grade bond will rate above a certain letter grade, generally in the middle “B” range.
Think of bond ratings as you would a personal credit score. You know that having a low credit score means that it will be more expensive to borrow money. You will pay a higher rate of interest.
Naturally, a high personal credit score means you are likely to pay less to borrow.
It’s the same thing with bonds, which are just another form of credit, after all. But why does this happen?
It’s really just supply and demand. More lenders will compete for the borrower with the high credit score. Competition drives down the cost of borrowing.
For instance, a borrower with great credit can expect a home loan to cost, perhaps, 3%.
A bank would issue a second borrower with middling credit a 5% loan, while the borrower with poor credit might be offered 7% or no loan at all.
Big bond issuers face the same type of free market process. If their bond rating is A+ or at least A, many lenders want to be a part of that.
The cost of credit falls and the rate these issuers pay is low.
Fall below investment grade, generally the middle of the “B” range (the actual letter scales are quite complex and vary by ratings agency), and the cost of credit goes up.
Major lenders want a large part of their lending portfolio to be built of investment grade bonds. Doing so assures them of a reliable flow of income.
Some lenders, meanwhile, specialize in lending to entities with lower ratings. For instance, some corporations issue what’s known as high-yield debt, or junk bonds. Those bonds are far below investment grade.
As result, those bonds pay a higher yield, albeit at a higher risk to the investors who own these bonds.
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