Just like consumers have credit ratings that help lenders decide whether to loan them money, companies have ratings that helps investors decide whether to loan money. When you purchase a bond from a corporation, you’re loaning money to that business. In exchange, the business pays interest on the bond for a certain period of time. (The periodic interest payments are known as the coupon payment.) Bonds from companies with the best credit ratings are known as investment grade bonds.
Credit Ratings For Companies
Companies are rated by companies like Standard & Poor’s and Moody’s. The ratings range from triple to C or D, depending on the agency. The highest rating indicates the company has a very low risk of defaulting on the bond, while the lowest rating indicates severe risk of default. Bonds from companies with above triple B rating are known as investment grade bonds.
Investment Grade Bonds vs. Junk Bonds
Investment grade bonds tend to have lower interest rates than junk bonds. That’s because companies offering junk bonds need to entice investors with a higher interest rate. Junk bonds are also known as speculative bonds and high-yield bonds.
The company’s credit rating can change over time. An investment grade bond can subsequently be downgraded to a junk bond if that business takes on too much debt or it the company’s financial future looks bleak. If you purchased a fixed rate bond, your interest rate won’t go up if the company’s credit rating drops. Meanwhile, new bonds may be issues at a higher interest rate.
While individuals have the option of investing in junk bonds if they choose, certain businesses can only invest in investment grade bonds. Most companies strive to have a high credit rating so they can continue to attract people and other companies to invest in those bonds.
Other Bond Features to Consider
Credit rating isn’t the only thing you should consider when you’re purchasing an investment grade bond. The yield spread is the difference between a bonds yield and that of current bonds offered by the U.S. Treasury. Treasury bonds typically have the lowest interest rate. So, if you find an investment grade bond with a good yield spread over Treasury bonds, investigate further.
Bonds may be callable which means the issuer can redeem the bond at any time. Once the issuer calls the bond, you’ll be repaid the face value of the bond – the amount you loaned to the business. When you redeem the bond either because it’s called or because the bond has matured, you’ll no longer receive interest payments on that bond. You’ll have to re-invest in another bond at current interest rates.
Bonds have different maturities – that is the amount of time you’ll hold the bond before you must redeem it. Bonds with longer maturities might sound attractive, especially if that bond has a good yield. However, long-term bonds are more risky, even investment grade bonds. A lot can happen to a company in the next 20 years, even if the company has strong financials today. Even if the company is just as sound in 20 years as it is now, inflation would likely devalue your bond.
Investment grade bonds, like other bonds, may have a minimum investment that’s $1,000 or more. You’ll have to put up at least the minimum investment to purchase the bond.
Other Risks With Bonds
Corporate bonds are not FDIC insured or guaranteed by any bank or government agency. It’s also important to note that lower yielding bonds come with certain inflation risks over time. Though bonds are generally considered a safe investment, there’s a risk that the bond could lose value if sold prior to maturity. This is especially true if market interest rates are higher than the rates on bonds you hold.