There are two ways for a company to raise financing: selling equity and issuing debt. In an equity sale, investors receive an ownership stake in the company and a claim on the profits distributed as dividends, if there are any. Bondholders do not take an ownership stake in the company, but receive regular interest payments at fixed intervals in the form of coupons. In the event of bankruptcy, bondholders are paid out before shareholders. Corporate bonds are perceived as being higher risk than government bonds, and therefore typically offer higher yields.
The credit rating of a company is calculated by the three large ratings agencies, Moody’s, Standard & Poor’s, and Fitch, in order to give investors a sense of the riskiness of purchasing their bonds. Credit rating tiers go from AAA, to B, to C, all the way to D. If a firm is rated BBB- or higher by Standard & Poors, or Baa3 or higher by Moody’s, its bonds are said to be investment grade. The financial position of the firm is judged to be healthy enough that the bonds are very likely to be repaid, and therefore safe enough for banks to buy.
The big three credit ratings agencies are paid substantial fees by the companies whose debt they assess, which has led to criticism that they are not impartial observers. After the collapse of the housing market in 2008, the Financial Crisis Inquiry Commission found the three ratings agencies had inaccurately assigned investment grade ratings to Asset-Backed Securities composed of risky subprime mortgage loans that eventually defaulted, leading to massive losses for investors that had relied on the agencies’ assessment.
Bonds that fall below the investment grade level are referred to as high yield bonds. Companies on the lower tiers need to offer higher interest rates to investors as compensation for the higher perceived risk of lending. These bonds are also called junk bonds because of the increased default risk.
The difference between a bond’s yield and the yield of a riskless asset such as a US Treasury security of similar tenor is called the risk premium. Currently risk premiums on both investment grade and high yield bonds are the lowest they have been since 2007, which means companies can borrow money very cheaply. For the most part corporations have been using this cheap cash to repurchase their own stock. By reducing the number of shares outstanding, share buybacks increase the earnings per share and lend support to a stock’s price.