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.