Investment grade bonds are those that aren’t very risky, meaning there’s a very high likelihood that the issuer, or borrower, repays all the interest and principles. But they’re slightly riskier than government debt, which has near-perfect credit.
Investment grade bonds are issued by corporations and households looking to buy homes or cars.
They have slightly higher yields, or interest rates, than government bonds do because they are slightly riskier. In markets, we demand a higher rate of return when there is higher risk.
High yield bonds are those that are very risky, meaning that there’s some discernible probability that the issuer can’t produce the cash flows needed to pay down all of the debt.
High yield bonds live up to the name. You guessed it. They yield a lot because the investor is demanding a premium rate of return as compensation for the risk he or she is taking.
Also, investment grade bond holders get paid before high yield bond holders and equity holders in the case of bankruptcy or liquidation. So if you’re getting paid close to last as a high yield debt holder, you’re of course demanding that risk premium.
This year, the coronavirus pandemic has wiped out revenues and profits from companies across numerous sectors. The Federal Reserve has provided stimulus in many ways, including by buying corporate bonds. The Fed injects cash into the bond market, bringing bond prices up and their yields down. That reduces the cost of borrowing for companies and therefore incentivizes it, which can keep people employed.
But the Fed has made it clear it would rather not buy high yield bonds. Therefore, companies that entered the pandemic already rated ‘junk’ because of their poor credit aren’t rewarded by the savior that is the Fed. Some investment grade companies became high yield companies during the pandemic. Those are called fallen angels.
To see how to approach the bond market, watch the quick video above.