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Credit ratings are one of the important measures for bond investors since these ratings are assessments of the creditworthiness of a borrower, such as a corporation, government, or a specific financial instrument like a bond. These ratings are assigned by privately owned credit rating agencies such as S&P Global, Moody’s, Fitch Ratings, or Scope. They indicate the likelihood that the issuer will meet its debt obligations (interest and principal payments) in full and on time. As a result, credit ratings help investors evaluate default risk, guide interest rates, and influence borrowing costs for bond issuers.

More generally speaking, ratings range from high-quality (AAA, AA) to lower-quality or speculative grades (BB and below). The ratings may include modifiers (e.g., “A+” or “A-”) to indicate relative standing within a category.

With regard to their rating, bonds are in general classified as investment grade or non-investment grade (high yield) bonds.

Investment grade bonds are bonds which are rated BBB- (S&P, Fitch) or Baa3 (Moody’s) or better. These bonds have a lower risk of default and a stable and predictable income. As a result of their lower default risk, investment grade bonds pay lower yields compared to high yield bonds. Investment grade bonds are in general preferred by investors with a low risk bearing capacity or by investors and institutions seeking steady, low risk returns.

High yield bonds are bonds rated below BBB- (S&P, Fitch) or Baa3 (Moody’s). These bonds have a higher risk of default due to issuer’s weaker financial stability and have to pay higher yields to compensate the investors for the increased risk. The difference between the yield of a high yield bond and a comparable investment grade bond is called “spread.”

Given their higher risk profile, high yield bonds are often used by investors who are seeking higher returns. Since high yield bonds have a different risk/return profile compared to investment grade bonds, they are also used as admixture to enhance the returns and/or diversification of investment grade bond portfolios.

That said, investors need to double check whether the strategy of a bond portfolio fits with their overall strategic or tactical asset allocation and their risk bearing capacity/risk tolerance.

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