When to trust bond rating agencies

0
Credit risk Moody’s Standard & Poor’s fitch reviews
Investment grade
The highest quality Aaa AAA AAA
High quality Aa1, Aa2, Aa3 AA+, AA, AA- AA+, AA, AA-
upper middle A1, A2, A3 A+, A, A- A+, A, A-
Average Baa1, Baa2, Baa3 BBB+, BBB, BBB- BBB+, BBB, BBB-
Not investment grade
Speculative medium Ba1, Ba2, Ba3 BB+, BB, BB- BB+, BB, BB-
Speculative lower category B1, B2, B3 B+, B, B- B+, B, B-
Speculative Risky Caa1 CCC+ CCC
Bad speculative position Caa2 CCC
Close to default Caa3, Ca CCC-, CC, C CC, C
In Default / Bankrupt VS D D

The notes

Each credit analyst will offer a slightly different approach to assessing a company’s creditworthiness. When comparing bonds on these types of scales, it is good to check whether the bonds are investment grade or not. This will provide the necessary foundation in simple and straightforward terms. However, higher quality bonds are not always better investments.

As an asset class, bonds with lower credit ratings actually have higher yields over the long term. On the other hand, their prices are more volatile. Basically, individual bonds rated below investment grade are more likely to default. Bonds with low credit rating are also called high yield bonds or junk bonds.

It is essential to remember that these are static ratings, as a novice investor can make long-term assumptions just by looking at them. For many companies, these ratings are always in motion and subject to change. This is especially true during difficult economic times, such as the 2008 financial crisis. Terms like “credit monitoring” should be considered when an agency makes a statement about its rating. A credit watch is usually an indication that a company’s credit rating will soon be downgraded.

Unfortunately, the way down is much easier than the way up. This is partly due to the way the system is designed. It takes a high-quality company to issue bonds as part of its capital structure. The investment grade bond market has historically dominated the high yield market. This market structure prevents rising companies from entering the bond market unless they issue convertible bonds. Even large companies have to withstand constant scrutiny.

Using Credit Ratings with ETFs and Mutual Funds

Individual companies and their credit ratings change too rapidly today to simply buy and hold individual company bonds. However, bond funds offer another approach for long-term investors. There are many mutual funds and exchange-traded funds (ETFs) that hold large collections of investment-grade or high-yield bonds for investors.

Bond funds are probably the best option for passive investors in a world where credit ratings change overnight.

Bond rating agencies made some big mistakes during the 2008 financial crisis, but they were generally right about asset classes. High-quality US Treasury ETFs hit new highs in 2008, while aggregate bond ETFs posted modest gains. Investment grade corporate bond ETFs lost money that year, and junk bond ETFs suffered heavy losses. This is precisely what one would expect based on credit scores.

The odds usually balance out when dealing with a large number of companies, so bond rating agencies can be trusted here. It is still possible to buy and hold a global bond ETF without worrying about rating changes.

Rather than trying to determine which individual bonds are undervalued, active investors can also focus on asset classes. For example, junk bonds were undervalued after 2008 and produced substantial gains in subsequent years. Emerging market bonds sometimes follow a different pattern than the rest of the bond market, so they can also outperform under certain conditions. Remember that you don’t have to bet everything on one category to beat the index. Investors can invest 80% in a global bond ETF and only invest 20% in a bond ETF that they believe will outperform.

How companies value rating

As crucial as it is for investors to review credit ratings, it is even more so for businesses. Rating affects a business by changing the cost of borrowing money. A lower credit rating means a higher cost of capital due to higher interest charges, resulting in lower profitability. It also affects how the business uses capital. Interest paid is often taxed differently than dividend payments. The basic premise is that the borrower expects to have a higher return on the money borrowed than the cost of capital.

Over time, credit ratings also have far-reaching effects on businesses. Ratings have a direct impact on the negotiability of their bonds on the secondary market. A company’s ability to issue stock, how analysts value debt on their balance sheet, and the company’s public image are also influenced by credit ratings.

The essential

History teaches us to use the information provided by credit rating agencies as a starting point. Their methods have proven themselves and until around 2008-2009 were rarely questioned. The value of ratings to companies themselves is paramount, as it can potentially determine the future of a company.

As financial markets have become more mature, access to capital markets and oversight have increased. In addition to increased volatility, loan markets experienced similar risks to equity markets. Diversification through ETFs and mutual funds is both more convenient and more important for investors in today’s bond market.

With the increased speed of financial information and market changes, bond ratings are essential decision-making tools. If you’re considering investing in specific bonds, look at both the ratings and their trend. If you don’t want to track rating changes, a mutual fund or ETF can do that for you.

Share.

Comments are closed.