Methodology

Investing Basics

Module 2

What is a portfolio?

Credit Ratings

When an investor invests their money into bonds, the greatest fear that they will have is that they won’t get their money back. This would happen if the organisation faced financial difficulties, leading them to default on their coupon payments. 

To overcome this problem, a credit rating system was developed to inform investors on how secure certain bonds are.

The credit rating system examines how likely a company is to repay their debts. They system allocates a score to each company by analysing the balance sheet of the business and by considering the external factors (i.e. competition) that could have an impact on the finances of the business.

There are two main organisations that provide credit ratings, which are ‘Moody’s’ and ‘Standard & Poor’s’. These organisations allocate a score to each bond, determining whether it is investment grade (low to medium risk) or junk (high risk).

Investment grade bonds

Investment grade bonds are bonds that are considered to be low to medium risk. Therefore, by investing in investment grade bonds, it has been determined that there is a low chance that the company would default on their debt.

The main organisations that offer credit ratings, Moody’s and Standard & Poor’s, have different grading systems to identify low to medium risk bonds.

When it comes to Standard & Poor’s system, AAA provide the very lowest risk, AA and A bonds are low risk, while BBB-rated bonds are medium-risk bonds. 

In terms of the Moody’s rating system, Aaa bonds are considered to be very low risk, Aa and A bonds are considered to be low risk, while Baa bonds are medium risk.

Of course, the higher the risk, the higher the return that an investor can expect on a bond. Therefore, medium risk bonds will offer larger returns than very low risk bonds.

Nonetheless, bonds that meet the investment grade status have been identified as being investment worthy. So, an investor should expect that the investment grade bonds that they invest in are more stable.

Junk bonds

Unlike investment grade bonds, junk bonds are considered to be high risk investments. This is the case because it has been determined that the company offering the bond is very unlikely to meet their debt obligations.

When investing in junk bonds, an investor should expect to not necessarily get their money back.

Although the companies that offer junk bonds may be established businesses, the highest risk junk bonds are offered by businesses that are already in default.

When it comes to how Standard & Poor’s rate junk bonds, BB and B bonds are considered to be high risk, CCC, CC and C bonds are considered to be very high risk, while D bonds are considered to already be in default.

With regard to Moody’s, Ba and B bonds are considered to be high risk, Caa, Ca and C bonds are considered to be very high risk, while C bonds can also be considered to be in default.

As the name suggests, junk bonds are sometimes so high risk that they are a waste of time. As you might expect, as they are so high risk, junk bonds offer very large returns to investors that are brave enough to take the investments.

For example, Ford was given junk status in 2020 and offered bonds with returns of up to 9.98%. This primarily happened due to the coronavirus pandemic.

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