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Bond Ratings: 3 Mistakes Investors Make

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Rating agencies have come under fire ever since the financial crisis of 2008-’09. In fact, recently there have been some legal settlements between the U.S. government and rating agencies in this area of the law. Some of the criticism is justified, while some is related to a basic misunderstanding by investors and even regulators. There are many traps that investors may fall into because they do not understand rating agency methods and how to view and utilize bond ratings.

Why are credit ratings important, anyway? Financial regulators use them to assign risk ratings to portfolios held by institutions such as banks and insurance companies. As a result, ratings influence how much capital a financial institution must set aside (“haircuts”) to invest in a particular bond (or preferred stock.) Prior to regulators using bond ratings this way, the ratings were not nearly so important, and were treated as a research opinion by a publisher representing their ideas and covered by First Amendment rules of free speech.

There has been movement afoot by regulators to de-emphasize the agencies’ ratings and use different sources and methodologies, but so far the biggest three agencies still have sway. Many other investors look to whether bonds are considered “investment grade” or “below investment grade” (aka: junk or high yield) as a “Good Housekeeping” seal of approval. This can be a serious mistake for a number of reasons. In many cases, institutional investors may not own bonds below investment grade and thus access to capital markets for these issuers is reduced and cost of borrowings are far higher. These bonds may also be much more difficult to trade once they lose their investment-grade ratings. So what are the errors?

First, some investors think a highly rated bond is in fact an investment recommendation. This is false. By definition, a rating tells you what a particular rating agency’s opinion of the probability of timely payment of principal and interest at a moment in time (default risk). It does not mean the bond is a good investment at a particular price as it trades in the market.

Furthermore, it does not necessarily tell you what could happen in the future. So a bond rating is not the same as an investment recommendation on a stock from an investment analyst, which factors in the stock price. In addition, if an issuer is small in size and not in the market frequently, the rating could also get stale due to lack of coverage. The agencies attempt to stay on top of credit situations, but there are no guarantees of this. The agencies have also tried to address this by adding an outlook as to whether a rating is stable or not, but in most cases, a rating is often a static evaluation rather than dynamic one.

Mistake number two is a bit more subtle. Ratings are not consistent across different types of debt, whether it be a corporate bond, sovereign bond, bank loan or a U.S. municipal bond. Investors in the financial crisis found this out to their sorrow. Those AAA rated structured bond products had far more risk than ratings would have led investors to believe. The agencies are now very frank about their disclosures on the differences and implications of ratings between different types of bonds. At one time, they toyed with the idea of trying to be being consistent across markets but subsequently dropped it when issuers and some investors protested. Making ratings consistent across markets is a difficult undertaking and tends to lower ratings in some classes of debt.

The various rating agencies have done long-term studies on default probabilities for some time now. For example, an A-rated general obligation municipal bond has about the same historical default risk as an AAA-rated corporate bond. Related to this, for corporate issuers, is the need to analyze the capital structure for a credit. A bank loan rated BB, for instance, may be far better secured than a BB-rated bond because it sits higher up in a company’s capital structure (it has a higher priority of payment.) Blindly looking at ratings without context can be a costly mistake.

Mistake number three is to think the ratings may give you insight into what happens in the event of a default. In other words, how much of his principal can a creditor recover once an issuer defaults? Recoveries vary a great deal depending on many factors, including type of debt, local law, and how issuers and creditors negotiate a work out. Ratings don’t take this into account. When rating agencies give estimates of how much might be lost by creditors, their opinion can be suspect as it’s not really core to their mission. Remember, bond ratings reflect the agencies view of the likelihood of default, not the outcome in the event of a default.

Ratings also don’t take into account the venue that resolves a default. There is no bankruptcy court for sovereign bonds, as an example.  By contrast, there is an established process for working out a bankruptcy for a U.S. corporation under various chapters in the U.S. bankruptcy code with established procedures and case law. Municipalities may file for bankruptcy under a different provision (Chapter 9), if their states permit it. US States may not file for bankruptcy, a fact that many people miss. Recently, one of the largest municipal defaults by Puerto Rico, a U.S. territory, caused the U.S. government to legislate a new procedure for a work out (the legislation is known as PROMESA.) Ratings don’t capture the complications after default or the subsequent remedies and loss experience for debt holders.

From the above we can conclude that while credit ratings can be useful, they can also lead inexperienced or naïve investors to have a false sense of security when using credit ratings in their investment process. An understanding of what credit ratings actually indicate, and do not indicate, is essential.