Long-term Corporate Debt: Investment-grade (IG) Vs. High-yield (HY) Bonds

AnalystPrep Summary

Investment-grade bonds are issued by financially stronger companies and typically carry credit ratings of BBB-/Baa3 or higher. High-yield bonds, also called speculative-grade or junk bonds, are rated below investment grade.

Because investors face greater default risk with high-yield issuers, these bonds generally offer higher coupons and wider credit spreads than investment-grade bonds. Investment-grade bonds are usually favored by investors seeking stability and capital preservation, while high-yield bonds may appeal to investors seeking higher income and willing to accept greater credit risk.

For CFA Level I candidates, the key is to understand how credit ratings, default risk, credit spreads, issuer fundamentals, and investor objectives differ between investment-grade and high-yield bonds.

Investment-Grade vs High-Yield Bonds

Feature	Investment Grade	High Yield
Credit Rating	BBB-/Baa3 or higher	Below BBB-/Baa3
Default Risk	Lower	Higher
Yield	Lower	Higher
Credit Spread	Narrower	Wider
Typical Investors	Conservative or institutional investors	Investors with higher risk tolerance
Price Volatility	Lower	Higher
Primary Driver	Interest rates and spread changes	Credit risk and issuer fundamentals
Common Name	Investment-grade debt	Junk bonds or speculative-grade debt

Key Takeaways

• Investment-grade bonds have lower default risk.
• High-yield bonds compensate investors with higher yields.
• Credit ratings determine whether a bond is investment grade or speculative grade.
• Bonds rated BBB-/Baa3 or higher are generally considered investment grade.
• Bonds rated below BBB-/Baa3 are generally considered high yield.
• High-yield bonds are more sensitive to issuer fundamentals and credit conditions.
• Credit spreads widen as perceived credit risk increases.
• Fallen angels are bonds downgraded from investment grade to high yield.

Understanding Investment-Grade and High-Yield Bonds

Corporate bonds are commonly classified as either investment-grade or high-yield based on the issuer’s credit quality. Investment-grade bonds are issued by companies with stronger financial positions and lower default risk, while high-yield bonds offer higher potential returns to compensate investors for accepting greater credit risk.

This distinction matters because credit quality affects bond yields, credit spreads, price volatility, investor suitability, and portfolio risk. A bond with a lower credit rating is not automatically a better investment because its higher yield reflects higher expected risk.

This study note explains:

• How investment-grade and high-yield bonds differ
• Credit ratings and default risk
• Yield spreads and credit spreads
• Typical investors in each market
• Fallen angels
• CFA Level I applications

Corporate issuers use long-term debt to secure stable funding for a range of requirements, from short-term operations to long-term capital investments. However, the features and availability of such funding vary based on the credit quality of the issuer. While IG corporate issuers showcase a strong capacity to meet future obligations, HY issuers are vulnerable in meeting debt interest and principal payments.

Similarities between IG & HY Issuance

Both IG and HY issuers are confronted with a series of considerations when issuing long-term debt. They weigh the relative risk against its costs or yield-to-maturity of long-term debt of different maturities. Moreover, both categories of issuers need to address concerns associated with interest rates, credit spreads, and maturity choices. The overarching issues of price risk, reinvestment risk, and rollover risk further bind these issuers in their decision-making process.

How Do Credit Ratings Determine Bond Quality?

Credit ratings help investors evaluate the creditworthiness of bond issuers and the probability that they will make promised interest and principal payments.

Major rating agencies include S&P Global Ratings, Moody’s, and Fitch. These agencies assign ratings based on factors such as financial strength, leverage, cash flow stability, business risk, industry conditions, and default probability.

Investment-grade bonds generally have ratings of BBB-/Baa3 or higher. Speculative-grade or high-yield bonds are rated below that threshold.

Credit ratings matter because they influence:

• Investor demand
• Bond yields
• Credit spreads
• Borrowing costs for issuers
• Portfolio eligibility for institutional investors
• Perceived default risk

For CFA candidates, the key threshold is the dividing line between investment grade and high yield.

Common Corporate Bond Ratings

Rating	Classification	Relative Risk
AAA	Investment Grade	Lowest
AA	Investment Grade	Very low
A	Investment Grade	Low
BBB	Investment Grade	Moderate
BB	High Yield	Elevated
B	High Yield	High
CCC and Below	High Yield	Very high

Why Do High-Yield Bonds Offer Higher Yields?

High-yield bonds offer higher yields because investors require compensation for accepting greater credit risk.

A bond’s yield can be viewed as compensation for several risks, including the risk-free rate, expected inflation, liquidity risk, and default risk. The additional yield above a comparable government bond is called the credit spread.

High-yield bonds usually have wider credit spreads because investors are more concerned about default probability, downgrade risk, refinancing risk, and recovery value if the issuer defaults.

When credit conditions weaken, high-yield spreads often widen. When investor confidence improves, spreads may narrow.

For CFA candidates, the key point is that higher yield usually reflects higher risk, not simply a more attractive return.

Distinguishing Features of IG and HY Bonds

Investment-Grade Bonds

• IG bonds often possess a lower proportion of YTM that’s attributed to credit spreads.
• These bonds come with fewer restrictions for issuers, primarily because they’re less likely to default.
• Cash flows from IG bonds are more predictable, aligning more with traditional bond characteristics.

Why Do Investors Choose Investment-Grade Bonds?

Investors choose investment-grade bonds because they generally offer more stable income and lower default risk than high-yield bonds.

Investment-grade bonds are commonly held by pension funds, insurance companies, banks, mutual funds, and conservative income investors. These investors may prioritize capital preservation, predictable cash flows, regulatory eligibility, and portfolio stability.

For issuers, investment-grade ratings usually result in lower borrowing costs because investors require less compensation for credit risk. Companies with investment-grade ratings often have stronger balance sheets, more stable cash flows, and better access to capital markets.

Investment-grade bonds are not risk-free, but they typically carry less credit risk than speculative-grade bonds.

High-Yield Bonds

• Their cash flows resemble equity investments, carrying an inherent uncertainty.
• A significant portion of their YTM is credited to issuer-specific spreads over benchmark yields, owing to the increased likelihood of default.
• These bonds often come laden with restrictions, and many are secured by tangible assets to appease wary investors.

Why Are High-Yield Bonds Riskier?

High-yield bonds are issued by companies with weaker credit profiles, higher leverage, less stable cash flows, or greater exposure to economic stress. Because these issuers have a higher probability of default, investors require higher yields as compensation.

High-yield bonds usually have wider credit spreads than investment-grade bonds. These spreads may widen further during recessions, market stress, or periods of declining investor confidence.

High-yield bond prices are often more sensitive to issuer fundamentals than to changes in benchmark interest rates. Investors must pay close attention to leverage, cash flow, industry conditions, refinancing risk, and recovery value.

The higher yield may be attractive, but it reflects higher credit risk, greater volatility, and a larger chance of loss.

Analytical Approach to IG and HY Bonds

For IG Bonds, analysts typically lean on financial ratios and credit ratings to gauge the potential shift in an IG issuer’s likelihood of default. On the other hand, given their high-risk profile, HY bonds demand a more intricate analysis. Emphasis is placed on evaluating potential losses in the event of default. Moreover, analysts closely examine covenants, restrictions, and security pledges tied to HY bonds.

Bond Maturities and Restrictions

Investment-Grade Bonds:

• IG issuers have a high flexibility in choosing maturities (up to 30 years).
• Their bonds typically carry few, if any, restrictive covenants.

High-Yield Bonds:

• Their landscape is more restrictive, marked by shorter maturity horizons, usually capped at 10 years.
• Given their risk profile, these issuers often find themselves renegotiating covenants or restructuring their debt to capitalize on favorable borrowing rates.

Investor and Issuer Implications

Investment-Grade Bonds:

• There is a high investor confidence in the IG issuer’s ability to meet obligations.
• Typically, IG issuers circulate multiple general obligation unsecured bonds. These bonds lack specific assets as collateral.
• IG Issuers stagger bond maturities across different periods. This strategy aids in risk minimization and ensures consistent capital availability.

High-Yield Bonds:

• HY bonds display unpredictable cash flows, similar to equity investments. This volatility stems from the issuer’s comparatively weaker financial standing.
• To mitigate default risks, HY bonds incorporate restrictive covenants. These covenants impose guidelines to safeguard investors.
• HY issuers operate within stringent frameworks. They confront challenges in issuing additional debt and experience marked fluctuations in credit spreads.
• HY issuers, aiming for financial adaptability, explore diverse borrowing options. They often resort to leveraged loans with prepayment features or bonds with contingency provisions.

Example: Comparing Two Corporate Bonds

Suppose Company A issues a BBB-rated bond yielding 5%, while Company B issues a BB-rated bond yielding 8%.

Company A’s bond is investment grade, while Company B’s bond is high yield. Although Company B offers a higher yield, investors demand that extra return because Company B has greater default risk.

If Company B’s financial condition worsens, the bond’s price may fall as investors demand an even higher yield. If Company B improves its credit profile, the bond’s price may rise as its credit spread narrows.

This example shows how credit quality affects yield, risk, and bond price behavior.

Fallen Angels

A unique subset within the high-yield universe is the “fallen angels” issuers. These are formerly investment-grade issuers who experienced a decline in their credit rating. However, their bonds still retain features characteristic of investment-grade instruments. These features include being non-callable, having minimal restrictions, and possessing longer maturities. However, any subsequent deterioration in the issuer’s credit quality can precipitate losses for the original investors. This decline is further exacerbated by the fact that the market for high-yield bonds is significantly smaller compared to the market for investment-grade bonds, which can have a pronounced effect on bond prices.

Why Do Fallen Angels Matter?

A fallen angel is a bond that was originally rated investment grade but has been downgraded to high yield.

Downgrades may occur because of weaker earnings, higher leverage, deteriorating cash flows, industry stress, or poor business performance. When a bond loses its investment-grade rating, some institutional investors may be forced to sell it because of portfolio rules or investment mandates.

This forced selling can place downward pressure on the bond’s price. However, some investors may view fallen angels as potential opportunities if they believe the issuer can recover.

For CFA candidates, fallen angels are important because they show how credit ratings affect investor demand, market liquidity, credit spreads, and bond pricing.

When Are Investment-Grade or High-Yield Bonds Appropriate?

Investment-grade bonds may be more appropriate for investors who prioritize income stability, capital preservation, lower volatility, and lower default risk. These bonds are often used in conservative fixed-income portfolios.

High-yield bonds may be more appropriate for investors seeking higher income and willing to accept greater credit risk, price volatility, and potential default losses. They may perform better during economic expansions when corporate earnings are strong and default rates are low.

The appropriate choice depends on the investor’s risk tolerance, income needs, investment horizon, diversification, and view of credit conditions.

Question #1

In terms of maturities, which bond issuer typically has the flexibility to choose maturities that can extend up to 30 years?

1. High-Yield Bonds
2. Fallen Angels
3. Investment-Grade Bonds

Solution

The correct answer is C:

Investment-Grade Bonds issuers have the flexibility in choosing maturities, and these can extend up to 30 years.

A is incorrect: High-Yield Bonds often have a more restrictive landscape, usually limited to maturities of 10 years.

B is incorrect: While Fallen Angels might retain some features of investment-grade instruments after a credit rating downgrade, the question specifically refers to the typical maturity of a particular type of bond, not a subset of issuers.

Question #2

In the context of credit quality, which of the following bonds typically carries a significant portion of its yield-to-maturity (YTM) attributed to issuer-specific spreads over benchmark yields?

1. Bonds with predictable cash flows
2. Investment-Grade Bonds
3. High-Yield Bonds

Solution

The correct answer is C:

High-Yield Bonds typically have a significant portion of their YTM credited to issuer-specific spreads over benchmark yields due to the increased likelihood of default.

A is incorrect: The predictability of cash flows does not directly determine the portion of YTM associated with issuer-specific spreads.

B is incorrect: Investment-Grade Bonds generally have a lower proportion of their YTM attributed to credit spreads, reflecting their lower default risk.

Glossary

Investment Grade — Bonds with relatively lower credit risk, generally rated BBB-/Baa3 or higher.

High-Yield Bond — A bond rated below investment grade that offers higher yield to compensate for higher credit risk.

Junk Bond — Another name for a high-yield or speculative-grade bond.

Credit Rating — An assessment of an issuer’s or bond’s creditworthiness.

Credit Spread — The additional yield a bond offers over a comparable risk-free or benchmark bond.

Default Risk — The risk that an issuer fails to make promised interest or principal payments.

Yield-to-Maturity — The annualized return an investor expects if the bond is held to maturity and payments are made as promised.

Coupon Rate — The stated interest rate paid by a bond.

Fallen Angel — A bond downgraded from investment grade to high yield.

Rising Star — A bond upgraded from high yield to investment grade.

Credit Risk — The risk that a borrower’s credit quality deteriorates or that the borrower defaults.

Speculative Grade — Bonds rated below investment grade.

Frequently Asked Questions

What is an investment-grade bond?

An investment-grade bond is a bond with relatively lower credit risk, typically rated BBB-/Baa3 or higher.

What is a high-yield bond?

A high-yield bond is a bond rated below investment grade. It offers higher yield because it carries greater credit risk.

What credit rating qualifies as investment grade?

Bonds rated BBB-/Baa3 or higher are generally considered investment grade.

Why do high-yield bonds offer higher returns?

High-yield bonds offer higher returns because investors require compensation for higher default risk, wider credit spreads, and greater price volatility.

What is the difference between BBB and BB bonds?

BBB-rated bonds are generally considered investment grade, while BB-rated bonds are considered high yield or speculative grade.

What are fallen angels?

Fallen angels are bonds that were originally rated investment grade but were later downgraded to high yield.

Are high-yield bonds riskier than investment-grade bonds?

Yes. High-yield bonds usually have higher default risk, wider credit spreads, and greater price volatility than investment-grade bonds.

How do credit ratings affect bond prices?

Credit ratings affect investor demand and required yields. Downgrades can cause bond prices to fall, while upgrades can support higher prices.

Which investors buy investment-grade bonds?

Investment-grade bonds are commonly bought by pension funds, insurance companies, banks, mutual funds, and conservative income investors.

What factors influence corporate bond credit quality?

Corporate bond credit quality is influenced by leverage, cash flow stability, profitability, industry risk, liquidity, management quality, and economic conditions.

Investment-Grade vs High-Yield Bond Summary

Concept	Investment Grade	High Yield
Credit Quality	Stronger	Weaker
Yield	Lower	Higher
Default Risk	Lower	Higher
Credit Spread	Smaller	Larger
Typical Maturity	Often longer	Often shorter
Investor Objective	Stability and capital preservation	Income and higher return potential