What Is Investment Grade?
An investment grade is a rating that signifies a municipal or corporate bond presents a relatively low risk of default. Bond rating firms like Standard & Poor’s (S&P), Moody's, and Fitch use different designations, consisting of the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating.
"AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality and are commonly referred to as junk bonds.
Key Takeaways
- An investment grade rating signals that a corporate or municipal bond has a relatively low risk of default.
- Different bond rating agencies have different rating symbols to signify investment-grade bonds.
- Investors and analysts commonly look at grades from rating agencies like Standard & Poor's, Moody's, and Fitch.
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How Investment Grade Works
Individuals and businesses are given credit ratings based on their credit histories. Lenders use these ratings to decide whether they will do business with and extend credit to potential borrowers. Similarly, investments are given credit ratings that lenders and investors can use to determine whether they want to invest in them.
Grades work just like credit scores for consumers and companies. An investment grade credit rating indicates a low risk of a credit default, making it an attractive investment vehicle, especially for conservative investors. A speculative grade, on the other hand, is the opposite of an investment grade. This grade indicates that the investment comes with a greater degree of risk.
Ratings are given to investments by different agencies, including S&P, Moody's, and Fitch. How they are rated varies based on the agency. For instance:
- hands out letter grades with plus (+) and minus (-) suffixes. Triple-letter ratings are higher, followed by double-letter ratings, then single-letter ratings.
- Moody's rates investments with triple-letter ratings as the highest, followed by those with a combination of letters and numbers.
- The Fitch rating scale is similar to that of S&P's
We go into more detail on these ratings and their scales below.
Special Considerations
Investors should note that U.S. government bonds, also known as Treasuries, are generally granted the highest possible credit quality rating. In the case of municipal and corporate bond funds, a fund company's literature, such as its fund prospectus and independent investment research reports, reports an "average credit quality" for the fund's portfolio as a whole.
In August 2023, Fitch downgraded the credit rating for the United States, moving it from a AAA rating to AA+. The agency cited potential issues with the country's fiscal condition over the next three years because of the political climate. According to Fitch,
"...repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management."
Fitch also stated that shocks to the economy related to tax cuts and increased government spending are raising the national debt, which could be problematic for the country's ability to pay its bills.
Many institutional investors have a rigid policy of limiting their bond investments solely to investment-grade issues.
Investment Grade Credit Rating Details
Investment grade issuer credit ratings are those rated above BBB- or Baa. The exact ratings depend on the credit rating agency.
Standard & Poor's (S&P)
Investment grade credit ratings include:
- AAA
- AA+
- AA
- AA-
Companies with any credit rating in this category boast a high capacity to repay their loans; however, those awarded a AAA rating stand at the top of the heap and are deemed to have the highest capacity of all to repay loans.
The next category down includes the following ratings:
- A+
- A
- A-
Companies with these ratings are considered to be stable entities with robust capacities for repaying their financial commitments. However, such companies may encounter challenges during deteriorating economic conditions.
The bottom tier of investment grade credit ratings delivered by Standard and Poor's include:
- BBB+
- BBB
- BBB-
Companies with these ratings are widely considered to be speculative grade and are even more vulnerable to changing economic conditions than the prior group. Nevertheless, these companies largely demonstrate the ability to meet their debt payment obligations.
Moody's
According to Moody's, investment-grade bonds comprise the following credit ratings:
- Aaa
- Aa1
- Aa2
- Aa3
- A1
- A2
- A3
- Baa1
- Baa2
- Baa3
The highest-rated Aaa bonds possess the least credit risk of a company's potential failure to repay loans. By contrast, the mid-tier Baa-rated companies may still have speculative elements, presenting high credit risk—especially those companies that paid debt with expected future cash flows that failed to materialize as projected.
Fitch
As noted above, Fitch ratings are similar to those issued by S&P. Investment grade ratings are as follows:
| Fitch Investment Grade Ratings | ||
|---|---|---|
| Rating | What it Means | Given to |
| AAA | Highest credit quality | Entities with exceptionally high quality (established, with consistent cash flows) |
| AA | Very high credit quality | Those with high quality and low default risk. |
| A | High credit quality | Entities with some business or economic vulnerability but low default risk |
| BBB | Good credit quality | Those with higher degree of business or economic vulnerability but a low expectation of default |
Downgrading from Investment Grade
Investors should be aware that an agency downgrade of a company's bonds from 'BBB' to 'BB' reclassifies its debt from investment grade to junk status. Although this is merely a one-step drop in credit rating, the repercussions can be severe.
The drop to junk status telegraphs that a company may struggle to pay its debts. The downgraded status can make it even more difficult for companies to source financing options, causing a downward spiral as costs of capital increase.
What Is Investment Grade vs. High Yield?
High yield bonds are generally considered higher risk than investment grade bonds. High yield bonds, however, tend to offer a higher return—to compensate for the higher risk of default of the issuer.
What Is Considered Investment Grade?
Investment grade is considered to be rated BBB- or higher for Fitch and S&P Global. Investment grade for Moody’s is considered Baa3 or higher.
What Are AAA Bonds?
Bonds that are rated AAA have the highest possible rating. The issuers of these bonds have the highest creditworthiness and are expected to easily meet financial obligations. AAA bonds have the lowest risk of default.
The Bottom Line
Credit ratings help banks, lenders, and financial institutions decide how likely consumers and businesses are to repay their debts using credit scores. Similarly, investors can determine whether to put their money into certain investments based on ratings by agencies like S&P, Moody's, and Fitch. The higher the grade, the safer the investment. Investments with lower ratings have a greater risk of default. Keep in mind that ratings can go up and down based on financial and economic conditions, so it's always a good idea to keep up-to-date with the news and your portfolio.
