Understanding the Importance of Investment Grades

A bond is simply a promise by the issuer of the bond to repay the face value of the bond. The issuer treats the proceeds from the sale of a bond as debt as opposed to stocks which are treated as equity in a company. Governments, financial institutions and companies use bonds to finance their long term borrowing needs. (More than a year)

Bonds which are investment grade are considered fairly certain to be repaid. In fact financial institutions are legally bound to only invest in investment grade bonds. Companies issuing bonds endeavour to obtain the highest credit rating they can acquire in order to help the sale of their bonds in terms of quantity and the lowest price possible.

It doesn’t matter how high an investment grade bond is rated when compared to a bond issued by a government, the non-government bond will always be considered riskier than the government issued bond. The difference between the rates of an investment grade bond and a government bond is called the spread. The spread is an indication of the economic climate in the country issuing the bonds. If the spread is low the economy is believed to be more stable by the forex markets. The higher the spread the more unstable the economy is deemed to be.

This phenomenon can be seen on the highest yield bonds more commonly known as Junk Bonds. Investors are always on the look out for the greatest return possible and a high yield bond would present an opportunity for a big return. The higher the yield of the bond, the greater the risk an investor faces when the bond matures, that he won’t receive the face value of the bond. Junk bonds are rated much lower than investment grade bonds specifically because of the nature of their risk.

Of course every investment has inherent risks. With bonds however, the risk is subject to the term to maturity of the bond and to its value. Many bonds are issued with maturities that can be 10 to 20 years from the issue date. This means that there is plenty of time for the economic situation of a country or a company to change and affect the value of a bond. Bonds which have many years to maturity are a more risky investment for the investor.

Another risk for the investor is interest rates. Bond yields move inversely with interest rates so that the higher the interest rate, the bonds value is lower and the lower the interest rate, the bonds value is higher. The longer the maturity of a bond the more affect interest rates will have on its value.

That is why it is important that investors check a bonds rating when considering investing. The rating indicates how experts have assessed the risk of a bond issue.