When to Trust Bond Rating Agencies

Institutional and individual investors rely on bond rating agencies and their in-depth research to make investment decisions. Rating agencies play an integral role in both primary and secondary bond markets. While the rating agencies provide a valuable service, the accuracy of such ratings came into question after the 2008 financial crisis. The agencies are often criticized when dramatic downgrades come very quickly.

Any good mutual fund, bank, or hedge fund will not rely solely on an agency's rating. They will supplement it with in-house research. That is why individual investors need to question the initial bond rating too. Furthermore, investors should frequently review the ratings over the life of a bond and continue to challenge those ratings as well.

Major Players

While there are several rating agencies out there, three leading agencies usually dominate financial news and move markets. These agencies are Moody's, Standard & Poor's (S&P), and Fitch. Agencies assign credit ratings for issuers of debt obligations, or bonds, in addition to ratings for specific debt instruments issued by those organizations.

The issuers of debt can be companies, nonprofit foundations, or governments. Each agency has its own models by which they evaluate the creditworthiness of a company. Ratings directly affect the interest rate that an organization must pay to buyers of its bonds and other debt.

A corporate credit rating is just like a personal credit score for anyone with credit card debt or a mortgage. The rating indicates how likely the company is to pay interest over the life of the bond. For a firm, this evaluation takes into account the potential marketability of the bonds over their life. The company's ability to return the principal when the bond comes due at maturity is always a crucial factor in assigning a rating.

Each of the three major agencies has slightly different ratings. However, all three have a full set of ratings. There is a top-level, reserved for the most creditworthy institutions, such as the Swiss government. Bonds that are in default often have the lowest ratings.

Bond Rating Grades

The Ratings

Every credit analyst will offer a slightly different approach to evaluating a company's creditworthiness. When comparing bonds on these types of scales, it is a good rule to look at whether the bonds are investment grade or not investment grade. That will provide the necessary groundwork in simple, straightforward terms. However, investment-grade bonds are not always better investments.

As an asset class, bonds with low credit ratings actually have higher returns in the long run. On the other hand, their prices are more volatile. Crucially, individual bonds with below investment grade ratings are more likely to default. Bonds with low credit ratings are also called high-yield bonds or junk bonds.

It is vital to remember that these are static ratings, as a novice investor may make long-term assumptions just by looking at them. For many companies, these ratings are always in motion and susceptible to changes. That is especially true in trying economic times, such as the 2008 financial crisis. Terms like "credit watch" need to be considered when an agency makes a statement about its evaluation. A credit watch is usually an indication that a company's credit rating will be downgraded soon.

Unfortunately, the path down is much easier than the way up. That 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 market for investment-grade bonds has historically dominated the high-yield market. This market structure prevents up-and-coming companies from entering the bond market unless they issue convertible bonds. Even larger companies must 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 corporate bonds. However, bond funds offer another approach for long-term investors. There are many mutual funds and exchange-traded funds (ETFs) that will hold large collections of investment-grade or high-yield bonds for investors.

The bond rating agencies made some prominent mistakes during the 2008 financial crisis, but they were mostly right about asset classes. High-quality U.S. Treasury ETFs soared to new highs in 2008, while aggregate bond ETFs made modest gains. Investment-grade corporate bond ETFs lost money that year, and junk bond ETFs took heavy losses. That is precisely what one would expect based on the credit ratings.

The odds mostly even out when dealing with large numbers of firms, so the bond rating agencies can be trusted here. It is still possible to buy and hold an aggregate bond ETF without worrying about rating changes.

Rather than trying to figure out which individual bonds are underrated, active investors can also focus on asset classes. For example, junk bonds were undervalued after 2008 and produced substantial gains in the following 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, it is not necessary to bet it all on one category to beat the index. Investors can put 80% into an aggregate bond ETF and place just 20% in a bond ETF that they believe will outperform.

How Companies Value the Rating

As crucial as it is for investors to review credit ratings, it is even more critical to the companies. The rating affects a company by changing the cost of borrowing money. A lower credit rating means a higher cost of capital due to higher interest expense, leading to lower profitability. It also affects the way the company 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 borrowed money than the cost of the capital.

Over time, credit ratings also have far-reaching effects on companies. Ratings directly impact the marketability of their bonds in the secondary market. The ability of a firm to issue stock, the way analysts evaluate debt on their balance sheet, and the public image of the company are also influenced by credit ratings.

The Bottom Line

History teaches us to use the information provided by the credit rating agencies as a start. Their methods are time-tested and up until around 2008-2009 were rarely called into question. The value of the ratings to the companies themselves is paramount, as it can potentially determine a company's future.

As financial markets became more mature, access to capital markets and scrutiny both increased. Along with the added volatility, the lending markets have seen risks similar to equity markets. Diversification through ETFs and mutual funds is both more practical and more important for today's bond market investors.

With the increased speed of both financial information and market changes, bond ratings are essential decision-making tools. If you are considering investing in specific bonds, look at both the ratings and their trend. If you are unwilling to stay on top of rating changes, a mutual fund or an ETF can do it for you.