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Bond issuers are ranked on a credit-worthiness scale to determine what rate of interest they should command based on risk
In this article, we are going to understand how bonds command different interest rates, why that happens, what credit scores mean, and why higher risk means a higher rate of interest in return. Investment-grade bonds are a category of bond investments that are considered baseline safe to invest in, based on several criteria.
Understanding investment-grade bonds
Investment grade bonds are debt securities issued by governments, corporations, or municipalities that are considered to have a relatively low risk of default. This means that the money you lend out to that entity has a high chance of coming back to you with the promised return.
Credit ratings
There are credit rating agencies like S&P, Moody’s, and Fitch evaluate the creditworthiness of bond issuers and assign them ratings.
These ratings are a crucial factor for investors deciding whether to buy a bond, as they indicate the likelihood of getting their money back.
Broad ratings categories are: Investment grade, which means high credit quality, and speculative grade, which means low credit quality.
Bonds with ratings of BBB- or higher by S&P and Fitch, or Baa3 or higher by Moody’s, are considered investment grade. These issuers have a strong capacity to meet their financial obligations.
Bonds rated below BBB-/Baa3 are considered non-investment grade, also known as high-yield or “junk” bonds. These issuers have a higher risk of default.
CTA: Credit rating
Criteria for determining credit ratings
There are several things that are minutely examined when these agencies assign their credit ratings to different governments and corporations. Here are some of them:
- The issuer’s financial strength: This is obviously the first sign of whether a business or a government will be able to return your money to you. The key metrics examined include profitability, leverage (debt), and cash flows.
- Industry risks: Certain industries, like cryptocurrency, are considered inherently riskier than others, like consumer staples. Higher risk corresponds to higher interest rates, which could very well correspond to lower ratings.
- Debt structure: The terms and conditions of the bond issuance, including the maturity date, collateral requirements, and presence of protective covenants also matter.
CTA: Debt instruments - Economic conditions: The overall economic climate and its potential impact on the issuer’s ability to generate revenue and meet its debt obligations is also important and is carefully examined.
What causes credit ratings to fall?
An investment rating downgrade, which signifies an increased risk of default, can occur due to various reasons.
If a bond issuer experiences consistent drops in profits, it raises concerns about their ability to meet future debt obligations, which can drive down credit ratings. This could happen when a company takes on more debt too, which means it will have a higher interest payment burden to deal with.
Additionally, a reduction in cash flows, regulations, economic downturns, and abrupt management changes can also cause credit ratings to fall.
Investing in investment grade bonds
There are several different types of investment grade bonds in India:
- Government bonds: Issued by the Indian government, considered the safest but offering the lowest potential returns. These include instruments like Treasury Bills (T-Bills) of the United States, Government of India (GoI) bonds, and Sovereign Gold Bonds (SGBs).
- Corporate bonds: Issued by companies with good credit ratings. They offer potentially higher returns than government bonds but carry slightly higher credit risk.
How to get started
Here’s how you can start your bond investing journey in India:
- Bond funds: These are professionally managed funds that invest in a basket of investment grade bonds. This offers diversification and potentially lower investment minimums compared to individual bonds.
- Exchange-Traded Funds (ETFs): Track a specific investment grade bond index, offering low fees and easy trading on stock exchanges. Popular options include Bharat Bond ETFs, which invest in government bonds.
- Individual bonds: You could also purchase bonds issued in the primary market from a broker but this could come with higher risk. Bonds of this nature also typically come with high minimums, which means you might have to invest a large amount in a single place for your money to be accepted. Since most retail investors are not comfortable taking that kind of risk with one company, bond funds are usually the way to go for most people.
Frequently Asked Questions
While investment-grade bonds are generally considered low-risk, there’s still a chance of price fluctuations. Since an emergency fund needs to be readily accessible, these bonds might not be the ideal choice. A high yield savings account might be your best bet here.
Fees associated with bond funds and ETFs can eat into your returns. Actively managed bond funds typically have higher fees compared to passively managed bond ETFs that track an index. Lower expense ratios translate to keeping more of your returns.
Laddering involves investing in bonds with varying maturities. This helps spread out your risk and ensures some bonds mature regularly, providing you with a steady stream of income and the opportunity to reinvest at potentially prevailing interest rates.
Many financial websites and news outlets track credit rating changes. You can also sign up for alerts from credit rating agencies to receive notifications when a bond’s rating is revised.