Part 2 in the series of articles from Dimitry Griko (pictured), CIO fixed income at EG Capital Advisors looks at investment grade vs high yield bonds.
Investment grade versus high yield bonds
Bonds with the highest credit quality and therefore the lowest risk of default are referred to as investment grade and will carry a lower yield. Those with a lower credit quality and a higher risk of default are referred to as non-investment grade, high yield or even “junk” bonds.
The steady payouts and secure characteristics of investment grade bonds mean institutions with short-term liabilities such as insurance companies and mature defined benefit pension funds will hold a significant proportion of their assets in these instruments.
The credit quality of bonds and their issuers is assigned by ratings agencies, usually one of Standard & Poor’s, Moody’s or Fitch. All of these use letters to rate bonds, but each one uses a slightly different system. The highest credit quality under each scale is AAA, with Moody’s using a combination of upper-and lower-case letters. However, it gets more complicated after this. Perhaps the most important rating to look out for is the one that separates investment grade from non-investment grade bonds. The lowest-rated investment grade bonds for each of the three main ratings agencies are as follows: Standard & Poor’s, BBB; Moody’s, BAA; and Fitch, BBB.
It is important to note that these ratings are not infallible: a high-profile example of their failings occurred during the financial crisis when many mortgage-backed securities rated as investment grade ended up defaulting.
Fund managers and traders carry out their own analysis on bonds and their issuers buying those they believe are undervalued and avoiding or selling those they believe are overvalued, sometimes taking advantage of mis rating.
It is more difficult to gain this sort of informational advantage with investment grade bonds, due to the high concentration of analyst coverage in this area of the market; there are much better opportunities in high yield bonds. Some fund managers refer to the area towards the top of the non-investment grade bond rating scale as “the sweet spot”, because a small uplift in the credit rating of these assets puts them on the radar of the major institutions.
A bond that has been downgraded from investment grade to non-investment grade status is sometimes referred to as a “fallen angel”.
While the lower risk of default in investment grade bonds means you are less likely to lose money in absolute terms than you are in their high yield counterparts, you can still lose money in real terms if the rate of inflation moves above that of the yield.