There are a host of reasons for considering investment grade bonds: diversification, capital preservation, an elevated stream of income compared to cash – the list goes on and on. Though bond detractors tend to point to the historically low interest rate environment in which we live as reason to avoid bonds, investors concerned with the stock market’s valuation or those that cannot handle rampant volatility may find considerable solace in owning a portfolio of individual bonds.
What Defines “Investment Grade”
Technically speaking, any bond deemed investment grade has received a rating of Baa3 or better by Moody’s and BBB- or better by Standard & Poor’s (S&P) or Fitch. The chart below summarizes the ratings handed out by the major rating’s agencies. Bonds that receive non-investment grade ratings are collectively known as “junk” bonds, although the term “high yield” is used interchangeably.
An investment grade rating is the “holy grail” for corporations, municipalities, school districts, and other organizations that borrow money through public channels. Many retail investors and investment institutions will simply not consider loaning money to any entity of non-investment grade caliber. An investment grade rating also, in general, results in lowered borrowing costs compared to entities that receive a junk rating or no rating at all (unrated or non-rated bonds).
For retail investors such as yourself, the investment grade moniker provides relative peace of mind insofar as return of capital is concerned. The trade off for that peace of mind is a lower rate of interest on your investment as opposed to what you might receive by investing in a junk bond.
Understanding The Nuances Of Investment Grade
Looking at the above credit chart, we see that there are ten disparate levels of ratings within investment grade, ranging from ‘AAA’ to “BBB-”. So even though an entity is deemed investment grade, there are distinct levels of creditworthiness within the investment grade realm. The reasons for differentiation are numerous and credit ratings agencies focus on an entity’s overall financial picture when applying ratings. Considerations include overall debt loads, assets, business fundamentals, as well as past, current, and future cash flows. Taken as a whole, the credit agencies apply their best assumption as to the current and future ability of an entity to repay its debt.
As things considered the further we move up the chart, the implication is for greater financial strength and corporate creditworthiness compared to corporations that sit lower on the chart. So while a ‘AAA’ rated company might be considered financially superior to a company rated ‘A’, both are still considered investment grade with a very high level of creditworthiness. A company rated ‘BBB-’, however, is one small misstep from falling into “junk” status.
Real Life Examples
The following four bonds were found during a search conducted with my online broker on Tuesday, November 26, 2013. I selected four bonds with roughly ten year maturities and ratings that encompass the investment grade universe (AAA through BBB). Here is the list:
These listings are what one might commonly find when searching for bonds on the secondary market. The column we want to focus on is YTM, or yield to maturity, as it represents our “bottom line” with regard to each bond. As one would somewhat expect, the yields progressively get higher as we progress from AAA- rated Microsoft to BBB rated Time Warner.
When a bond is trading at or near par, the annual yield to maturity will be at or near where the coupon (interest rate) of the bond sits. The Wells Fargo bond is a perfect example of this. It is trading near 100 and its YTM of roughly 4.05% is almost identical to its stated coupon of 4.125 percent.
When bonds are trading at discounts or premiums to par, the YTM may be lower or higher than the stated coupon. In the case of the Norsk Hydro bond, which trades at 132, the YTM is less than one half of the stated coupon.
Which Bond Represents The Best Value
While our eyes might immediately gravitate towards the Time Warner bond trading with a nearly 5.75% YTM, there should be some consideration to the fact that it sits at the low end of investment grade. Thus for someone that might possess a negative view towards this business or is uncomfortable with “non-A-rated” bonds, the attractive yield might not be worth the 10-year chance that it slides into “junk” status.
Microsoft and Wells Fargo are pretty much household names and should probably be considered solid bonds, yet let us not forget in the case of Wells Fargo, the trouble the banking industry got into just five years ago.
Norsk Hydro, a name many might not be familiar with, is a Norwegian aluminum and renewable energy company. So despite its solid credit rating and assumedly strong balance sheet and business model, a lack of familiarity with this company could certainly pose rationale for passing on the bond.
Without a doubt, superficially speaking, the best bang for our buck would be the Time Warner bond. Yet yield and price should not be one’s only consideration when selecting fixed income investments. Value is always in the eye of the beholder. If Microsoft’s 3.27% means more to you knowing you’ll never have to worry or think about the position, then it may represent more value to you than Time Warner’s 5.75% and the potential for it to drop into junk status. There is always value in a good night’s sleep!
While there may not be a reason to get overly excited about investment grade bonds due to historically low interest rates, there is certainly strong rationale for continuing to buy and own them in today’s market. Whatever your consideration for them is, take the time to peruse the scope of offerings, evaluate your personal situation and risk tolerance, and select the issues that best fit your personal needs and goals.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.