High yield and investment-grade corporate bonds: A key guide (Part 1 of 4)
What are investment-grade corporate bonds?
Investment-grade corporate bonds (LQD) are debt securities issued by corporates rated BBB- or above by credit rating agencies such as Standard and Poor’s or Moody’s. These corporates are issued ratings based on their financial strength, operational past performance, and future prospects. Corporates with higher earnings, limited debt exposure, and potential to perform receive good credit ratings. An example is Apple Inc. (AAPL), an American multinational corporation headquartered in Cupertino, California, that designs, develops, and sells consumer electronics, computer software, and personal computers. It’s rated AA+ and has a stable credit outlook. However, corporates rated below BBB- are non–investment-grade assets.
Non–investment-grade bonds are divided into two sub-categories: leveraged loans (BKLN), rated BB+ or below and paying an interest rate of more than LIBOR 1 + 125 basis points, and high yield bonds (JNK), rated below BBB-. (To learn more, please see Comparing leveraged loans and high yield bonds: A guide).
As the name suggests, high yield bonds normally compensate investors for the comparatively greater risk associated with investing in issuers with lower credit ratings by offering a higher interest rate compared to other classes of bonds. The Sprint Nextel Corporation (S), commonly known as Sprint, is a United States telecommunications holding company that provides wireless services and is also a major global Internet carrier. It’s a good example of high yield bonds with corporate credit rating of BB-.
Ratings are essential from both investors’ and issuers’ points of view. For an issuer, credit rating is a strong reflection of a company’s credibility. Issuers with a higher rating stand a greater chance of accessing the credit markets than below-average corporates. Plus, investors can benchmark the risk and return of an investment based on the corporate’s rating.
The risk associated with investment-grade corporate bonds is less than high yield bonds. (Remember, the higher the credit rating, the lower the risk). The difference between the rates of return for investment-grade corporate bonds and high yield bonds is known as the “junk-to-investment-grade spread.” This spread, also called “credit spread,” is the premium investors demand in order to hold high yield bonds over lower-yield investment-grade corporate bonds.
Another significant difference between high yield bonds and investment-grade corporate bonds is interest rate risk. Read on to the next part of this series to learn more.
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