Definition of investment grade

Investment grade issue or issuer ratings are all ratings above BBB — or Baa — included.

Investment grade issues are considered from 'extremely strong capacity to meet financial commitments’ (AAA or Aaa) down to 'adequate capacity to meet financial commitments but more subject to adverse economic conditions’ (BBB or Baa).

In practice the investment grade status for an issuer or issue is key as many investors are restricted by federal regulations, private contracts including rating triggers or investment guidelines to invest in investment grade instruments.

Private contractors use ratings triggers extensively in loan and bond covenants. These triggers are contractual provisions that give counterparties and lenders the right to terminate the credit availability, accelerate credit obligations, or have the borrower post collateral in the event of a rating action, such as when the rating falls below a certain level.

Moody’s reported that in 2001, "out of 771 US corporate issuers rated Ba1 or higher, only 12.5% reported no triggers, while the remaining 87.5% reported a total of 2819 rating triggers."

On the demand side, counterparties often require triggers as a kind of security. Lenders may require rating triggers as protection against credit deterioration, asymmetric information problems, and prospective losses, especially in cases where a borrower faces a serious likelihood of bankruptcy or default. The rights given to the creditors usually vary from an increase in the nominal coupon to a put option.

There is, however, also a supply-side reason for rating triggers to reduce the cost of debt. Borrowers are willing to include such triggers because, without them, lenders, out of fear of event risk, would demand a higher initial spread on debt contracts,  or may not be willing to lend as much.

Hence, issuers that are downgraded below investment grade to speculative grade see their cost of capital increase and their financing options diminish. The extent by which credit ratings from the global rating agencies are embedded in regulations and contracts is such that even investors that are not bound by these may have to react substantially to a downgrade to a speculative grade. [1]