Bond Investment Grade Introduction
The word Bond Investment Grade basically means the rating given by accredited agencies on the credit worthiness of an organizations Bonds but before we can determine whether or not the government bonds are Investment grade, we must first understand the key difference between investment grade bonds and non-investment grade bonds.
Non-Investment Grade Bonds
Non-investment grade bonds are low-quality bonds that are at risk of default due to the issuing company’s high level of debt in comparison to its level of equity. These bonds, also known as Junk bonds, have a higher risk of default than other bonds, but they pay higher returns, making them appealing to investors.
Standard & Poor’s non-investment grade ratings range from BB to lower; Moody’s Investors Service ratings range from Ba1 to lower. Fitch Ratings considers anything below B to be non-investment grade.
Investment Grade Bonds
So, if non-investment grade bonds are risky, then investment grade bonds are clearly the “safest” bonds to invest in. They are usually low-risk, which means they are far less likely to default. Consider Apple, which has a solid reputation and a track record of selling a lot of iPhones each year.
If they were to issue a bond today, it would almost certainly be classified as investment-grade since Apple is one of the most solid and trusted companies in the world, with a devoted fan base.
The likelihood of them failing to repay the bond is low because people have used their products and everyone trusts them due to their dependability. As a result, their bonds qualify as investment-grade.
These bonds account for the majority of the market, but despite the fact that they are less risky than Junk bonds, they have low interest rates. They are typically used to fund working capital and regular business operational processes. So, how are these bonds rated?
What is the Bond Investment Grade ?
Bonds are rated using the Bond Investment Grade. Bond issuers are generally evaluated by their own set of rating agencies to assess their creditworthiness, just as people have their own credit history and rating issued by credit bureaus. Standard & Poor’s, Moody’s and Fitch are the three major rating agencies that assess the creditworthiness of bonds.
Their assessments of that creditworthiness, or the organization’s monetary ability to make loan repayments in full at maturity, determine the bond’s rating and, in turn, the yield the issuer should pay to entice investors. Lower-rated bonds typically offer higher yields to help compensate for the increased risk.
- Depending on the rating agency, investment grade ratings range from Aaa/AAA to Baa3/BBB.
- Below BBB-/Baa3, they are considered sub-investment grade, also known as junk bonds if they have never been rated investment grade as well as fallen angels if they have been downgraded below investment grade.
- Sub Investment grade ratings vary from BB1/BB+ to C/C, via B1–3/B+,- and Caa/CCC. Investment grade reviews are important because some investors have obligations to only buy investment grade, while others, such as banks and insurance companies, may only have limited capacity for sub investment grade.
In a nutshell, “investment grade” refers to any rating that is higher than BBB-. This corresponds roughly to possessing a default rate of less than 4%. Anything rated lower than investment grade is referred to as “junk” or “non-IG.” Many funds are unable to purchase junk debt. Historically, the Fed has not lent money in exchange for junk bonds. However, highly specialized junk bond funds as well as operators exist.
The Significance of an Investment Grade Rating:
- Non-investment grade bonds are not permitted to be held by a significant portion of the institutional investing world (pensions, endowments, and investment) (and most individuals simply chose not to). As a result, the demand for non-investment grade is narrow and specialized, whilst investment-grade is in high demand, making it simple to buy and sell.
- Investment-grade bonds almost never default. Just under 1% of all investment-grade bonds issued in history have ever defaulted. Almost all were downgraded before they defaulted.
How the Ratings Differ Between Credit Rating Agencies
Here is what the various rating grades (from Standard & Poor’s) mean. Investment grade is defined as BAA and above. As the likelihood of default increases, the ratings assigned are AA, A, BBB, BB, B, CCC, and so on, often with + and – thrown in (this is the S&P convention; Moody’s has equivalents that use capital and small letters, but same letters). Fitch and Standard & Poor’s both use a plus or minus marker. For instance, A+ is superior to A, and A is superior to A-.
Moody’s assigns numerical modifiers 1, 2, and 3 to each standard rating classification ranging from Aa to Caa. You can think of this as an ordinal ratings model ranging from 1 to 10. For example, A1 is superior to A2 (but still not better than Aa3)
Keep in mind that ratings are not at all perfect and can’t tell you whether your investment will increase or decrease in value. Learn about the methodologies and criteria used by each ratings agency before using ratings like one factor in your investment selection procedure. Some methods may be more useful to you than others.
Are Government Bonds Investment Grade ?
Since they are backed by the government, most government bonds are viewed as investment grade. However, this is not a hard and fast rule;
There have been cases of governments defaulting and their bonds being rated as junk bonds, for example. Greek bonds were assigned a “junk” rating by US financial rating agencies in 2010.
As money began to dry up, Greece encountered a liquidity crisis, forcing the government to pursue bailout funding from the International Monetary Fund, which they eventually received with stringent conditions.
Bailout money from the International Monetary Fund as well as other European creditors were contingent on Greece implementing budget reforms, specifically spending cuts and increased tax revenues. These austerity measures triggered a vicious recessionary cycle, with unemployment rates reaching 25.4% in August 2012.
The Advantages of Investing in Government Bonds
Anyway, that is an extreme example, but government bonds do have benefits and financial advantages especially for sophisticated investors. Some of the benefits government bonds have over other asset classes is:
- They are not correlated to stock markets, which is extremely beneficial when diversifying your portfolio. Bonds are purchased by investors for risk-aversion purposes, as they seek to hold their money in a less volatile investment than stocks. Volatility is the degree to which the price of a security fluctuates over time.
- Most investors include bonds in their portfolios in order to generate income. A bond is a debt security which generally pay an interest rate, known as a coupon rate, to the bondholder each year. Although buying and selling bonds to profit from price fluctuations is a legitimate strategy, most investors buy them for the interest payments.
- Short-term ones continue to rise when markets fall, as they did in 2008–2009. Even during the Covid declines, short-term bonds performed reasonably well.
- Even if they are not be performing well at the moment that does not mean they will always perform poorly. The “death of bonds” has been referred to numerous times throughout history. We shouldn’t judge assets solely based on what they produce today.
- Bonds can still help people who are dealing with high volatility by mitigating the more severe falls. If you invest 60% in equities and 40% in bonds, your portfolio will not fall as far in bad times, but it will also not soar as far in good times. Experienced investors, on the other hand, learn not to be afraid of volatility.
- They still have a place in a portfolio for those nearing retirement and in the preservation phase. For younger people, a small allocation, say 10%, can still make sense. However, high-quality bonds are currently paying very little. Furthermore, stock markets (not individual stocks, but the entire market) have always outperform bonds over the long term
That meant that younger investors should always be light on bonds but heavy on stocks before settling on a 60/40 or 50/50 distribution when they are older. There has been no point in taking risks on uncorrelated alternative assets when bonds could pay 6% annually.
What has changed is that it is now relatively simple to outperform govt bonds with alternative assets, which can include high-quality corporate bonds.
Having many relatively small alternative investments to partially substitute the bond allocation can increase returns, especially for people who are more sophisticated or have access to an advisor. Of course, increasing one’s risk-adjusted return, rather than just return, is the key, and this requires some thought, skill, research, and so on.
Difference Between Bonds & Bond Etfs
Bond funds and Bond ETFs, also known as exchange-traded funds, both invest in a portfolio of bonds or debt securities. Bond funds or rather mutual funds are pools of capital from investors that are allocated to various securities by the fund’s manager. A bond ETF tracks a bond index with the objective of matching the underlying index’s returns.
The decision to buy a bond fund or perhaps a bond ETF is usually influenced by the investor’s investment goals. Bond mutual funds provide more options for active management. Bond ETFs are a good choice if you looking to trade frequently. Bond mutual funds and bond ETFs can meet the needs of long-term, buy-and-hold investors, but it’s best to do your research on the holdings in each fund.
If transparency is important to you, bond ETFs enable you to see the fund’s holdings at any time. If you’re worried about not being able to sell your ETF investment due to a lack of buyers in the market, a bond fund might be a better option because you’ll be free to sell your holdings back to the fund issuer.
