The credit quality of a bond is determined by independent agencies in the form of a rating. The rating applied to a bond measures the financial strength of the issuer and how likely it is that they will be able to make interest payments and ultimately repay the principal of the bond upon maturity.
Standard and Poor’s rating system considers ‘investment grade’ bonds as those rated AAA, AA, A or BBB. It is important for issuers to secure an investment grade on their bond (if possible), as this general group of ratings showcases issuers that are most likely to be able to pay off their debt obligations, when the time comes.
Bond ratings play a key role for investors as these ratings inform them of the best investment options on the market. More importantly, however, bond ratings affect the interest rate that a company or government agency will pay on their issued bonds. Therefore, an investment grade bond will help to lower the cost of their interest payments.
Bond rating agencies are crucial lifelines for investors as they provide these investors with a bond grading system based on up-to-date market research and data. A rating system, such as that used by Standard and Poor’s (S&P) indicates the likelihood that the issuer will default on interest or capital payments. Standard and Poor’s ratings begin at AAA (the most secure) and progress to their lowest rating of D. With the latter rating indicating to potential investors that the issuer is likely to default and it is therefore a profit is unlikely to be made.
For institutional investors, BBB bonds are considered suitable due to institution’s size and access to capital. However, bonds below BBB rating are considered to be below investment grade and therefore not recommended investments, regardless of the size of the investor.