“Gentlemen prefer Bonds” – Andrew Mellon Investing has become synonymous with stocks. However, stocks fail in the realm of safety and stability. In such a case, bonds are the safest instrument for an investor. While stocks are a great option and carry a very high-risk reward ratio not suitable for all investors. Investors should always think of a mix of investments that will diversify their risk and make a proper portfolio.
From the above chart, we can easily see that even if bonds have provided less return than equity, they have outperformed stocks in hard times and given consistent returns.
Investment in bonds is essential for investors with passive income needs. The issuers of bonds are generally governments and large corporates.
Depending on the credit rating, a bond can be either an investment grade or a non-investment grade.
So, should you invest in investment grade or non-investment grade bonds? Before going to that section, let us understand what credit rating is and what it means for bonds.
A credit rating shows how likely the borrower is to return investors’ money, i.e., what is the borrower’s creditworthiness.
A credit rating helps both the borrowers and investors. It helps borrowers by raising money for their projects. It will also help the investors to make sound financial decisions by analyzing which bond to invest in.
The borrowers are given credit ratings by credit rating agencies (CRA). These are institutions that evaluate the borrower’s creditworthiness.
Before giving a rating, a CRA takes into account many factors such as the promoter’s background, the issuer’s repaying capacity, its business with past performance and future growth in coming years, current and future liabilities, economic development, global economic scenario, regulatory changes, etc.
In India, credit rating agencies include CRISIL Ltd, ICRA Ltd, CARE Ltd, and India Ratings and Research Pvt Ltd, among others.
The credit rating rates papers from AAA to D are based on how safe the instruments are for investing.
All the credit rating agencies have their rating structures and terminology.
Like in CRISIL, the credit rating is as follows:
SYMBOL
SAFETY LAVEL
AAA
HIGEST SAFETY
AA
HIGH SAFTY
A
ADEQUATE SAFTY
BBB
MODERATE SAFTY
BB
INADEQUATE SAFTY
B
HIGH RISK
C
SUBSTANTIAL RISK
D
DEFAULT
AAA, AA, A, and BBB are investment-grade bonds, and BB to D are non-investment-grade bonds (also known as high-yield bonds or junk bonds).
Investment-grade bonds are those bonds that carry low default risk. On the other hand, non-investment grade bonds have a high default risk.
So, which investment-grade bond should you look for?
Choosing Between Various Grades of Bonds
Investment-grade bonds (AAA, AA, A, and BBB) are preferable bonds as they carry a low default risk compared to non-investment-grade bonds.
‘AAA-rated bonds for Investment are advisable for the following reasons:
They have the highest degree of safety, so they will own their obligation in time towards interest and maturity amount.
AAA-rated bonds have less correlation with equity, which helps an investor to diversify the portfolio.
AAA-rated bonds are considered as safe as risk-free
‘AA’ & ‘A’ rated bonds for Investment are also considered suitable for the same reasons.
On the other hand, if you buy a non-investment-grade bond, there is much higher chance of losing your principal amount.
Are bonds ratings trustworthy?
Credit rating agencies give credit ratings to any borrower by analyzing the different financial parameters after careful evaluation, and it is evaluated on a regular interval of time. The rating of the company might have differed from one borrowing to other.
According to the report by CRISIL, 98.6% of its AAA rating bonds remained AAA-rated even after one year and 1.4% were downgraded to AA, this happened between 2011 and 2021.
The rating of the company can move downwards (like AAA to AA to A to BBB to D) and upwards like (A to AA to AAA).
One important point to note is that no CRA can guarantee that an AAA rated bond as on date will not default or downgrade in the future.
For example, issuers such as Infrastructure Leasing & Financial Services (IL&FS) and Dewan Housing Finance Limited (DHFL) had AAA ratings at one point. However, their ratings downgraded to D in less than one year when these bonds defaulted.
Many large institutional investors have also started setting up internal rating mechanisms to discover the credit quality of issuers.
Why not choose lower-rated bonds for Investment?
Low-rated bonds do not always default or a bad investment option. It all depends upon your risk tolerance, time, and goals.
If an investor is willing to take a high risk and wants to earn a higher return, he could choose a low-rated bond. However, before investing, they should consider its pros and cons.
Not borrowing money to generate extra interest income on these Bonds as can be very risky as you might not be able to pay back the borrowed money.
Further, lower credit rating bonds are illiquid, i.e., if an investor sells the bond before maturity, he/she might have to give it at a steep discount to fair value.
Conclusion
Investing in AAA-rated bonds or AA or low-rated bonds is the choice of the investors. An investor, after considering the pros and cons of both and their risk appetite should make a call.
Investment-grade bonds are less risky but also offer low returns. These bonds are suitable for those investors who are looking for a stable income, the safety of their investment, and are risk-averse.
Investors should also know that credit ratings should not only be the factor while investing in a bond, as credit rating is not a guarantee of safety. It is simply an opinion of the credit rating agency.
Credit ratings should be used only as a broad filter to pick out quality bonds before digging deeper into the bond’s valuation metrics.
An investor should do thorough research before investing in bonds.
One more vital point to note is that investors should not be attracted to high yields in bonds before understanding their risk because high yield is always associated with high risk.
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