Why Bad Bonds Get Good Ratings

Investopedia

Credit ratings were developed to provide a way to assess a company's financial strength, and its likely ability to repay investors in a timely manner. Ratings can be an important indicator of an issuer's financial stability, as well as a helpful tool in determining the relative safety of buying a company's debt. However, ratings alone tell only part of the story. Learn why you, as a bond investor, should not limit your bond investing criteria to credit ratings, and which additional criteria you should examine before making a bond investment.

Potential Weaknesses of Credit Ratings

While credit ratings are helpful tools in making an investment decision, they're not perfect. Below, we'll go over some of the weaknesses associated with credit 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.

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.

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.

Are Bond Ratings Still a Helpful Investment Criterion?

Given all their potential weaknesses, investors may wonder whether ratings are still worth assessing. The answer is yes. While not infallible, ratings provide an important determinant of a company's demonstrated historical ability, and therefore inferred future ability, to perform on its debt commitments. In addition, ratings analysts, while human, still provide a critical expert assessment of a company's financial health. Investors should consider credit ratings as one important piece of their bond investment decision-making process.

Other Factors to Evaluate for Potential Bond Investment

Seasoned bond investors know that ratings alone should not guide their investment choices. So what other factors should you carefully consider?

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.

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 also want to 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 a 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.

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.

The Bottom Line

Know why you're investing in bonds, and carefully read the prospectus for the bond issue you're considering before you make a choice based solely on its rating. Although a credit rating can be quite useful, it does not provide a complete picture of the bond, and there are other factors that need to be taken into consideration.

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