Thin capitalisation: practical guidance: loan pricing and the use of credit ratings: the distinction between ‘investment grade’ and ‘speculative grade’
The market for non-investment grade or ‘speculative grade’ bonds
As indicated in INTM524140, bonds with a credit rating below a particular level are termed non-investment grade, or “speculative grade” bonds (also known more pejoratively as “junk bonds”).
Although there is undoubtedly a market for these bonds, the market is smaller, though still in billions of dollars or equivalent. Furthermore, the market in these instruments is substantially less liquid than the market in investment-grade bonds. As a consequence, institutional investors - who are the major lenders in the bond markets, will usually steer clear of the most speculative types of investment. Mutual funds and government-run pension funds often operate a policy restricting their investments to certain grades of bonds, typically excluding those rated as speculative.
The tendency of major investors to avoid higher risk bonds may mean that a bond issue may not be fully subscribed, so that there are risks for the borrower as well as the lender in trying to raise debt via the bond markets. Whether or not a debt issue is fully subscribed will also depend on unquantifiable aspects such as investor appetite for the sector and demand for bonds with a particular maturity date.
Speculative grade bonds are also known as high yield bonds, because they yield a higher return than investment grade bonds, in order to attract investors willing to take on riskier investments.
The importance of the investment grade/non-investment grade boundary
The distinction between investment grade and speculative grade is of some significance in the pricing of loans. The reducing appetite, mentioned above, as ratings move from investment grade to speculative grade tends to cause a significant increase in the arm’s length cost of funds. The increase in interest rate when moving down the investment grade rating scale will generally be proportional until the speculative grade boundary (BBB-) is reached, at which point interest rates will go up sharply, often by several hundred basis points. This jump reflects not only the additional risk premium in moving from BBB- to BB+ (across the investment grade / speculative grade boundary) but also the liquidity premium demanded by investors for holding a less liquid asset - one that cannot be so easily traded and turned back into cash.