Investment And Non-Investment Grade Bonds

What are Bonds?

Bonds can be considered an agreement between the lender and borrower that outlines the loan terms and the associated payment method. Bonds are fixed-income securities that companies, municipalities, states, and sovereign governments use to finance operations and projects.

Categories of Bonds

It is critical to understand that, just as each individual has a credit report and rating provided by credit bureaus, bond issuers have rating agencies that assess their creditworthiness; for example, their ability to pay interest and repay the loan in full at maturity. Three primary rating agencies evaluate bond creditworthiness:

• Moody’s rating
• Standard & Poor’s
• Fitch.

These rating agencies have their unique way of rating a bond. Moody's, Standard & Poor's, and Fitch add an indicator to their ratings to show where a bond ranks within a category. Moody's makes use of a numerical indicator. For example, A1 is superior to A2 (but still not as good as Aa3). Fitch and Standard & Poor's use a plus or minus indicator. For example, A+ is superior to A, and A is superior to A-.

After noting this, we can now say that based on Moody's, Standard & Poor's, and Fitch Ratings, bonds fall into two categories, namely:

• Investment Grade
• Non-Investment Grade.

Investment-grade bonds: These bonds have a higher credit rating than high-yield corporate bonds. Investment grades bonds are bonds with high and medium credit quality. Different agencies assign different patterns to the ratings. For Instance, S&P uses capital letters in the order of best to worst rating. It follows the pattern AAA, AA, A, BBB, BB, and B up to D. Example of Investment Grade.

• As per S&P’s investment-grade rating, the following are a few rated bonds in the United States.
• Kansas Dev Fin Auth (AAA rated)
• Hopkins Pub Schs (A rated)
• Willis North America Inc. (BBB rated)
• Michaels Stores Inc. (B rated)
• As per S&P’s investment-grade rating, below are a few rated bonds in the United Kingdom.
• Towd Point Mortgage Funding 2018 – Auburn 12 PLC (AA rated)
• Lloyds Bank Corporate Markets PLC (A rated)
• FCE Bank PLC (BBB rated)

Advantages of Investment Grade

• Less Risky: Investment-grade bonds have a low risk of default; in essence, you are very less likely to lose your money. The reason for this is that risk is not correlated to equity. And, the value of your investment grade bonds is much more likely to remain constant daily. In the unlikely event that a company goes bankrupt, bondholders are paid out before its stockholders, making it much more likely you’ll see a total return on the amount you invested.
• Allows Investors Can Track Any Changes In The Credit Rating Of Bonds: One of the advantages of investment-grade bonds is that Investors can track any changes in the credit rating of bonds. For example, if there is a drop from BBB to BB, it means the bonds are reclassified to junk bond status. Although the drop is only one level, the impact is severe, and the risks vary.
• Higher Yield: On investment grade bonds, Investors can sell a good-rated bond and gain by selling at a higher price. Similarly, at low times, they can buy bonds when the price declines for which they anticipate a hike in price.
• Good Income Generation: Income investors and retirees prefer investment-grade bonds because they produce a regular, reliable income stream. While certain stocks offer dividends, the payments aren’t guaranteed like bond interest payments are.

Disadvantages of Investment Grade

• False Credit Rating: Many companies may project false cash flows and financial positions to obtain a good rating.
• Rating Is Not Fixed: Rating is not fixed and as such, it is prone to change at any point for a short period. However, when this happens, the creditworthiness of the investment companies may be affected for an extended period.
• Less Liquidity: Finding investors to sell off your bonds to during emergencies can be very difficult.  This is because Bonds cannot be sold in bits nor accessible until their maturity date. Although if you can sell your bonds on the secondary market, you may have to sell at a loss.
• Less Transparency:  Since most corporate bonds are traded over-the-counter (OTC), there is less liquidity and price transparency in the market. Financial advisors advise most investors to stick with bond funds rather than individual bonds because this increases the likelihood that you will pay more than you should.

Non-investment grade bonds,  A bond is considered non-investment grade if it has a lower credit rating, implying higher credit risk, than investment-grade bonds and, therefore, offer higher interest rates in return for the increased risk. Rating agencies rate non-investment grade bonds as; BB+ from Standard & Poor's and Fitch, or Ba1 or below from Moody's.  High-yield bonds are typically broken down into two sub-categories:

• Fallen Angels: Due to the issuing company’s subpar credit standing, this bond has been downgraded by a significant rating agency and is on the verge of becoming a junk bond.
• Rising Stars: A bond with a rising star rating has seen an improvement in credit quality from the issuing company. Even though a rising star may still be a junk bond, it is moving in the direction of investment quality.

Advantages of High-Yield Bonds

• Investors choose high-yield bonds for their potential for higher returns; High-yield bonds provide higher yields than investment-grade bonds if they do not default.
• The bonds with the highest risks also have the highest yields.

Disadvantages of High-Yield Bonds

While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry several risks like default risk, higher volatility, interest rate risk, and liquidity risk.

• Default Risk; Default is itself the most significant risk for non-investment-grade investors. The primary way of dealing with default risk is diversification, but that limits strategies and increases fees for investors.
• Higher Volatility; Unlike investment-grade bonds, Non-investment grade bonds have been seen to be more volatile.
• Interest Rate Risk; All bonds face interest rate risk. This is the risk that market interest rates will rise and cause the price of a bond to decrease. The price of bonds moves opposite to the price of market interest rates. The longer a bond’s term, the higher the interest rate risk because there is more time for interest rates to change.
• Liquidity Risk: Unlike Investment Grade Bonds, High-yield bonds generally have higher liquidity risks. When bonds are traded frequently, they have higher liquidity. Liquidity risk is the risk that you won’t be able to sell an asset at the time and for the price that reflects the actual value of the bonds.

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