Investment Grade

An investment grade is a rating that indicates that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such as Standard & Poor's and Moody's, use different designations consisting of 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."

Credit ratings are important because they communicate the risk associated with buying a certain bond. An investment grade credit rating indicates a low risk of a credit default, making it an attractive investment vehicle.

Investors should note that government bonds, or Treasuries, are not subject to credit quality ratings, and these securities are considered to be of the very highest credit quality. In the case of municipal and corporate bond funds, the fund company literature, such as the fund prospectus and independent investment research reports, will report an "average credit quality" for the fund's portfolio as a whole.

Investment grade issuer credit ratings are those that are above BBB- or Baa. The exact ratings depend on the credit rating agency. For Standard & Poor’s, investment grade credit ratings include. AAA, AA+, AA, and AA-. Companies that have credit ratings in this category have a very high capacity to repay their loans, with AAA rated companies having the highest capacity to repay.

The next category down includes companies with A+, A, and A- ratings. These are companies that have a strong capacity to repay their financial commitments. These companies are currently stable and easily able to repay their debts, but could face challenges if economic conditions deteriorate. The bottom tier of investment grade credit ratings includes BBB+, BBB, and BBB-. These companies are considered "speculative grade" and are vulnerable to changing economic conditions and could face big challenges if economic conditions decline. When rated, however, these companies have demonstrated both the capacity and capability to meet their debt payment obligations.

According to another important ratings agency, Moody's, investment grade bonds comprise those with a credit rating of Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2 and Baa3, with Aaa being the highest rating. Aaa rated bonds possess the least credit risk, while Baa are mid-tier and may still have speculative elements. Credit risk means a company may not repay a loan, possibly because it expected to use future cash flows toward the debt and did not generate the cash it expected. 

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 with just a one-step drop in quality. While it is just a one-step drop in credit rating, the repercussions can be severe. The drop to junk status shows that the company could quickly run into difficulties in paying its debts, especially as the company will see its cost of capital increase and its financing options shrink as a result of the downgrade.