Why Bad Bonds Get Good Ratings

• Based on Potentially Biased Information
  Credit rating agencies are not independent auditors. They assign ratings primarily on the basis of financial statements that the issuing company or government provides to them. Agency analysts do not undertake independent research, they analyze information and use statistical models to determine the likelihood of default based on the information the issuer provides. If the issuer provides faulty or incomplete information, the agency's rating will be based on that incorrect information.
  
  
• Cannot Account for or Predict Fraud
  Because credit rating agencies work with information that the issuer provides, they cannot predict potential defaults due to fraudulent activity on the issuer's part. (Be sure to read our Investment Scams Tutorial to learn more about fraudulent activity within companies.)
  
  
• Not Fully Objective
  Rating agencies have come under some scrutiny regarding their ability to remain objective when the majority of their income comes from fees paid by the bond-issuing organizations that they are rating. In addition, bond issuers can hire agencies for consulting advice on how to best structure securities in order to get a positive rating. Also, because rating agencies work so closely with their customer firms, the possibility that analysts could assign a slightly more or less favorable rating based on personal relationships with executives in companies or governments issuing debt always exists. (Check out The Debt Rating Debate to see how lack of competition and potential conflict have called the value of these ratings into question.)
  
  
• Lagging Indicators 
  Because agencies assign ratings based on past corporate and market performance, they are considered "lagging indicators". This means that the agency's ratings changes typically come after it would be beneficial for an investor to make the change to either buy, if the rating improves, or sell, if the rating drops. 

• Call and Put Provisions
  Call and put provisions are redemption features that can change how long you maintain your bond investment. If you want the protection that comes from knowing you can oblige the bond issuer to repurchase your debt investment before it matures and repay your principal, you'll want a bond that has put provisions. Put provisions are especially important if the interest rate environment changes significantly and you want to move out of your bond investment and reinvest your money into a security that offers a more attractive rate. Likewise, make sure you know if the bond has a "call provision" that allows the issuer to repay you for your investment before the bond's stated maturity date. (To learn more about provisions, read The ABCs Of The Bond Market.)
  
  
• Issuer's History of Credit Downgrades
  A bond will be downgraded - assigned a lower rating than it was initially given - when something changes either with the bond itself or the underlying economic fundamentals of the company, government or organization that issued the bond. 
  
  
• Offsetting Compensations for Investors in Event of Downgrade
  Some issuers will take proactive measures in order to assure potential investors of their commitment to performing on their debt securities by offering some form of compensation if the security is downgraded. 
  
  
• Investment Goals and Objectives and the Bond's Features
  While it may seem obvious, in addition to examining the financial health and ability of a bond's issuer, it's important to know the bond's features (i.e. duration, yield, maturity, etc.) and how those features match up with your investment goals. For example, consider an 'AAA'-rated bond with a 20-year maturity. While the bond has a very attractive and competitive 'AAA' rating, if your primary bond investment objective is to realize high yields, you may want to also consider bonds with lower ratings.
  
  Bonds with lower ratings have correspondingly higher yields, as they are going to have to pay higher yields to attract investors. However, if your primary bond investment objective is to minimize your interest rate risk, a highly rated bond will put you at greater risk for interest rate changes compared to a bond with a lower credit rating and shorter maturity. This is because of its long maturity period. (Be sure to check out our Advanced Bond Concepts Tutorial to learn more about the features of bonds.) 
  
  
• Expenses and Fees 
  Bonds are typically priced with a built-in markup that includes the broker or dealer's profit. If your broker or dealer does not have a bond in his or her inventory that you are considering for investment, you may need to pay an extra commission fee. Most dealers keep a fairly substantial portfolio of previously-issued bonds for their clients. If you are investing in a bond fund, you may have to pay an annual management fee. Also, if you invest in a bond fund or bond unit investment trust, you may have to pay a small sales fee. (Read Don't Let Brokerage Fees Undermine Your Returns to learn how smart investors don't give away more money than necessary in commissions and fees.)

by Katie Adams, (Contact Author | Biography)

Katie Adams is a freelance commercial writer, marketing and public relations professional with 18 years experience. She has written extensively about financial issues and was previously Director of Regional Communications for Fannie Mae. Adams earned a B.A. from the College of William and Mary and lives with her family in Virginia Beach, Virginia. She is actively involved in international philanthropic work to improve orphan care and accelerate sustainable development in Central America. Visit her website at www.katieadams.homestead.com.