What Is Credit Quality

Credit quality is one of the principal criteria for judging the investment quality of a bond or bond mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio's creditworthiness or risk of default. A company or security’s credit quality may also be known as its “bond rating."

Key Takeaways

  • Credit quality is a measure of how likely a bond issuer is to repay its loan.
  • A credit-quality rating can be assigned to an individual bond issuer or to a portfolio of bonds.
  • Lower-rated bonds are more likely to default and, as such, must offer a higher yield.

Understanding Credit Quality

Credit quality is an important aspect of the credit markets. An individual bond or bond mutual fund's credit quality is determined by private independent rating agencies such as Standard & Poor's, Moody's, or Fitch, among others. Each rating agency has its own credit quality designations which typically range from high ('AAA' to 'AA') to medium ('A' to 'BBB') to low ('BB', 'B', 'CCC', 'CC' to 'C').

Credit rating agencies issue credit quality ratings for all types of issuers in the credit market. Factors that influence a corporate credit rating include the company’s capital structure, credit payment history, revenue, and earnings.

Credit quality ratings for developed-market countries, such as the United States, are typically on the higher end of the credit quality spectrum and promise investors investments with low risk of default. In the credit market, investment-grade ratings are typically perceived as high quality. Non-investment-grade bonds, also called high-yield or "junk" bonds, have lower credit quality and higher risk. Investment-grade bonds often have lower yields while non-investment grade bonds require higher yields to offset the greater risk.

Investors interested in the safety of their bond investments should stick to investment-grade bonds ('AAA', 'AA', 'A', and 'BBB'), while investors willing and able to accept a higher level of risk might consider lower credit-quality bonds with higher yields, if they believe for whatever reason that these borrowers with low credit are likely to repay.

Factors that influence a corporate credit rating include the company’s capital structure, credit payment history, revenue, and earnings.

Examples of Credit Quality

In the investable market, investors have a wide range of mutual funds to choose from, with varying credit qualities. Mutual funds offer investors the opportunity to invest in a diversified portfolio of bonds with targeted credit quality exposure. Below are examples of some of the top bond funds in the government and high yield credit-quality categories.

Eaton Vance Short Duration Government Income Fund

This fund focuses on short-term U.S. government debt. The Fund offers A, C, and I share classes. It invests in high-quality, short-term U.S. government and U.S. government agency bonds. The fund’s average duration is less than three years, which gives it limited interest-rate risk. As of July 30, 2019, the Fund had a one-year return of 2.1%. Its gross expense ratio was 0.89%.

Highland Opportunistic Credit Fund

The Highland Opportunistic Credit Fund is a high-yield bond fund. Its one-year return after fees for A-class shares was -9.2%, as of July 31, 2019. The fund had an expense ratio of 1.74% for A-shares. The Fund invests for total return. As of Dec. 31, 2018, 32.2% of the fund was invested in CCC securities.