What Are Class 3-6 Bonds?

Class 3-6 bonds get their name as a result of their bond classification, which is determined by their investment grade. An investment grade is a rating that signifies the level of risk of a municipal or corporate bond, or the likelihood that the bond will go into default. Credit ratings are extremely important because they convey the risk associated with buying a certain bond.

Key Takeaways

  • Class 3-6 bonds get their name as a result of bond classification, which is determined by their investment grade.
  • Class 3-6 bonds are one of several classes of non-investment grade bonds that are held by an insurance company as reserves.
  • Class 3-6 bonds are considered to be the most risky type of bonds issued by insurance regulators and are more likely to go into default.

Understanding Class 3-6 Bonds

The National Association of Insurance Commissioners (NAIC), the standard-setting regulatory body governed by state insurance regulators, divides bonds into different classes based on their investment grade. Classes 1 and 2 are considered investment-grade bonds, which are the least risky, or the least likely to go into default. Classes 3 through 6 are considered non-investment grade bonds; they are considered a low-quality investment because the issuer may default. Class 6 bonds are the most risky type of bonds to invest in.

Class 3-6 bonds are one of several classes of non-investment grade bonds held by an insurance company as reserves. Class 3-6 bonds are considered to be the most risky type of bonds issued by insurance regulators and are more likely to go into default.

There are many types of bonds that can be classified in the Class 3 through 6 bond range. For example, bonds that are at or near their default limit are considered Class 6 bonds and carry a high amount of risk.

Special Considerations

Analysts use a variety of ratios to determine the viability of an insurance company. A basic analysis can include a review of the percentage of each bond class compared to the company's total bonds. Healthy bond portfolios carry less risk; they will have more Class 1 and Class 2 bonds. Examples of bond ratios include:

Non-Investment Grade Bonds (Class 3-6) to Total Bonds

This ratio shows the proportion of a company’s bond portfolio at a greater risk for default and nonperformance compared to all bonds.

Non-Investment Grade Bonds to Surplus and Asset Valuation Reserve (AVR)

This ratio shows how potentially non-performing bonds compare to the company’s reserves.

Class 6 Bonds to Total Bonds

This ratio shows the proportion of a company’s portfolio that is considered non-performing or near default.

Class 6 Bonds and Non-Performing Mortgages Compared to Total Bonds and Mortgages

This ratio shows how much of a company’s bond and real estate assets are non-performing.

By evaluating the classes of bonds an insurance company invests in, investors can gain an understanding for the risks a company may face if the number of claims it receives increases. If an insurance company is unable to meet its obligations it may be deemed an impaired insurer, and if it is unable to improve its finances when impaired it may ultimately go bankrupt.