Introducing Investment Grade Corporate Bonds

Investment grade corporate bonds are the highest-rated and consequently the least-risky amongst debt instruments aside from Treasury securities (the shorter the duration the better, of course).  For the price of a little extra volatility, intermediate grade corporate bonds can also earn investors significantly better return compared to the ultra safe but low-yield Treasuries. The term investment grade is used by credit ratings agencies to inform potential investors of a bond’s relatively low risk of default. It is more of a label of risk classification based on an agency’s internal credit rating system; less of a stamp of investment approval by any one organization. Individual investors have to make their own judgment about whether a corporate bond is indeed investment grade under their different investment standards.

Bond Rating System

All three major credit ratings agencies, Moody’s, Standard & Poor’s, and Fitch, have a rating system that uses letters A, B, and C, including the lower-case ones, in combination with numbers 1, 2, and 3, as well as plus sign (+) and minus sign (-) to denote different credit risk levels for bonds or short-term notes, corporate and municipal. Note that Treasuries are not subject to these credit ratings. The highest credit rating, as we all know, is referred as triple A, expressed in AAA by S&P and Fitch, and Aaa by Moody’s. Under their rating systems, credit qualities are classified into three categories: high credit quality for AAA level and AA level (or Aaa and Aa), medium credit quality for A level and BBB level (or Baa), and low credit quality for BB (or Ba), B, various C levels, and etc. Within each credit level, there are three sub-notches to further distinguish among the different degrees of likelihood of potential credit risks. By credit rating definition, investment grade must have a medium credit quality as rated at least at the BBB (Baa) level. The lowest notch within this level is BBB- from S&P and Fitch, and Baa3 from Moody’s, which becomes the investment grade threshold. Anything that falls below BBB- or Baa3 would be considered junk bonds or high yield bonds, carrying a speculative grade.

The average credit rating of almost any bond mutual fund can be found at Morningstar.com (I recommend signing up for a free account to gain access to their portfolio tools and forums).

Investing In Investment Grade Corporate Bonds

Bond ratings are not guarantees but rather indications of the likelihood of any potential credit default. Moreover, ratings can change from time to time and in the event of a credit downgrade, it affects not only the issuer in terms of having to pay higher borrowing costs, but also bond investors who would likely see their bond prices going down. Because not all investment grades are rated the same, to avoid potentially serious downgrade situations, safety-conscious corporate bond investors should consider investing in mostly A-rated bonds, excluding all BBBs if possible although bonds at that level are still deemed to be investment grade. While it’s unlikely that a bond even with the lowest A rating, i.e. A- would ever easily fall into junk bond status, a BBB rating at any notch can be much quicker in dropping down to the BB level in major downgrades, causing a bond to lose investment grade status.

Though carrying higher risks than government issues, corporate bonds of better qualities can make a good addition to your portfolio in addition to equities and perhaps real estate or commodities as well. As long as risk concerns are addressed by staying above the investment grade threshold of BBB- with enough cushion, the risk-return trade off is likely to be favorable.