What Are Investment-grade Bonds?
Investment-grade bonds—also known as "high-grade" bonds—are debt securities issued by corporations and municipal governments that are generally considered to have a low risk of default. Bonds in this category are generally rated Baa or better by Moody's Investors Services and BBB or higher by S&P Global Ratings and Fitch Ratings, the three main credit rating agencies.
By contrast, bonds rated below these designations are called non-investment grade. Also, those in the lowest credit categories are generally considered to be speculative in nature and called high-yield or "junk" bonds. They have a relatively high risk of default.
By definition, investment-grade bonds usually exclude "risk-free" securities such as U.S. government securities, which are generally considered to have little or no default risk.
Because of their unlikelihood to default, investment-grade bonds typically yield less than those with poorer ratings, although slightly more than U.S. government bonds. Lower-rated bonds yield more. Investors are willing to accept a lower yield for less risk, while they demand a higher yield in return for accepting more risk.
Relation To Bond Ratings
While not perfect, bond ratings have been a good predictor of default. Historically, there is a strong correlation between high bond ratings and low defaults, and vice versa. Default rates among corporate bond issues differ markedly based on credit rating.
According to S&P Global's 2018 Annual Global Corporate Default and Rating Transition Study, which tracked corporate bond performance over a period of more than 30 years, the highest one-year default rates for bonds rated AAA, AA, A, and BBB were 0%, 0.38%, 0.39%, and 1.02%, respectively. By contrast, the highest one-year default rate for bonds rated BB, B, and CCC/C were 4.22%, 13.84%, and 49.28%.
Because of the high risk of loss that investing in below investment-grade bonds entails, many institutional investors, such as bank trust departments, insurance companies and pension funds, are required to only invest in investment-grade bonds. However, many investors are willing to accept the risk of default for higher yields. Many mutual funds and exchange-traded funds invest in lower rated bonds, which spreads the risk among a large portfolio.
Investment-grade bonds—also known as "high-grade" bonds—are debt securities issued by corporations and municipal governments with the strongest credit ratings. They have the lowest risk of default. Bonds in this category are generally rated Baa or better by Moody's Investors Services and BBB or higher by S&P Global Ratings and Fitch Ratings, the three main credit rating agencies.