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Investment grade usually refers to municipal government or corporate bonds that are considered to be of high quality and relatively low risk. This grade is a credit rating determined by a ratings agency, such as Standard & Poor's® (S&P), or Moody's®. Different agencies have various levels of credit ratings. Investment grade bonds usually have a rating of medium risk or better.
A bond is a debt the issuer has to pay back to the investor who purchased the bond. Issuers pay interest on bonds, then pay back the original investment on the bond after a set period of time. A credit rating is basically a way to measure the investment community's confidence in the issuer's ability to pay its debts.
When an issuer has too much debt, investors may start to doubt the issuer's ability to repay. This can result in lower credit ratings. Ratings agencies generally use a combination of the letters A and B for investment grade credit ratings. S&P® ratings of BBB or higher, and Moody's® ratings of Baa or higher indicate investment grade bonds. Bonds are given these high ratings when there is a low risk of the issuer defaulting on the bond.
An issuer defaults on a bond when it is unable to pay the investor any interest due, or to repay the original amount invested in bond. A bond that is rated below investment grade is generally called a junk bond. Junk bonds have a high risk of default. There is usually a higher rate of return to compensate the investor for the higher risk of default.
Credit ratings can change based on the issuer's financial stability. If a ratings agency determines there is an elevated risk of default, the credit rating may be lowered. When a credit rating is lowered, it is known as a downgraded rating. When the risk has passed, and the issuer's financial situation has stabilized, the credit rating can go back up.
U.S. Treasury bonds are considered to be of the highest grade, with the lowest risk, since they are issued by the federal government. As a result, these bonds are not assigned credit ratings. For others, investors can usually find the credit rating listed in a prospectus, company literature, or on the issuer's website. Ratings can also be found on the ratings agencies websites.
Credit ratings are not infallible. Issuers can default on investment grade bonds. Bonds can also have different credit ratings assigned by the various ratings agencies, though they are usually similar. An investment grade credit rating is usually only one factor investors use to determine if a bond will be a good investment.