Credit ratings provide a useful measure for comparing fixed-income securities, such as bonds, bills and notes. Most companies are issued a rating based on their financial strength, future prospects and past history. Companies that have manageable levels of debt, good earnings potential and a good debt-paying records will have good credit ratings.
Investment grade refers to the quality of a company's credit. In order to be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's. Anything below this 'BBB' rating is considered non-investment grade. If the company or bond is rated 'BB' or lower it is known as junk grade, in which case the probability that the company will repay its issued debt is deemed to be speculative.
Any time that you purchase or sell bonds, bills or notes, they will have an associated credit rating. This rating changes over time as the company's strength and debt load changes. If a company takes on more debt than it can handle or if its earnings outlook weakens, the company's rating will be lowered. If it reduces its debt or finds a way to increase potential earnings, the company's rating will usually increase.
Which Securities Are Considered Investment Grade?
In finance, government and private fixed income securities, such as bonds and notes, are considered investment grade if they have a low risk of default. Investment grade is determined based on a relative scale by credit rating agencies such as Standard & Poor's and Moody's. Such credit ratings express the ability and willingness of a borrowing organization to repay its debt and are based on many financial and economic indicators that influence the borrower's creditworthiness. Securities with a rating of BBB or above from Standard and Poor's or Baa3 or above from Moody's are considered investment grade.
Credit ratings represent forward-looking statements about the creditworthiness and credit risk of a particular organization in meeting its financial obligations. The credit ratings give an indication of a default risk for an individual debt, a municipal bond, a government bond or mortgage-backed securities (MBS).
When constructing its rating, the credit rating agency takes into account a myriad of factors to come up with a well-balanced view of credit risk. Leverage, cash flows, earnings, interest coverage ratio and other financial ratios are common indicators that the credit rating agency considers to assign an investment grade to a specific security.
A security has an investment grade rating if it has a rating that falls within the range of Aaa to Baa3 from Moody's or AAA to BBB- for Standard & Poor's. The company's securities have investment grade ratings if it has a strong capacity to meet its financial commitments.
The rating of BBB- from Standard & Poor's and Baa3 from Moody's represents the lowest possible ratings for a security to be considered investment grade. BBB- and Baa3 ratings indicate that the company that issued such securities has an adequate capacity to meet its obligations, but it can be subject to adverse economic conditions and changes in financial circumstances.
It is common for a security to lose its investment grade rating. The reasons for such events vary and can be related to changes in the overall business environment such as recession, industry-specific problems or the company's own financial problems.
If there is a recession, it is likely that many companies are struggling to generate enough cash flow to cover their interest and principal repayments, and credit agencies can lower the rating of companies across sectors. A change in technology or the emergence of a rival within an industry can also warrant downgrades of securities rating from investment grade to speculative grade. Another common reason for the loss of a security's investment grade is due to the company's own problems, such as taking too much leverage, problems with collecting on accounts receivable and regulatory changes.
The rankings from credit ratings agencies should be taken with caution. During the financial crisis of 2007-08, it became evident that credit rating agencies misled the public by giving AAA rating to highly complex mortgage-backed securities market. It turned out that these MBS were high risk investments and their ratings were soon downgraded to speculative grade from investment grade.