Investors researching individual bonds are likely to be confronted with a confusing “alphabet soup” of letters in individual bond listings, for example Baa1/BBB+. Those letters reference ratings from major credit ratings agencies (usually Moody’s & S&P) and indicate the strength of a company’s ability to pay back its debt obligations. The below chart taken directly from another LearnBonds article, summarizes the general meaning of the ratings.
Corporate borrowing costs to a certain extent are predicated on the rating(s) that are issued to them by the major agencies. The lower a company’s ratings sit in the above chart, in general the higher its borrowing costs will be. From an investment perspective, the higher you sit on the chart, the “safer” your bond is, but the less compensation you will receive because you’ve assumed less risk. The opposite is also true.
The more conservative one is, the more a portfolio should be skewed toward individual investment grade issues (BBB- or better). For those with a higher risk tolerance, variable exposure to high-yield (BB+ or lower) through individual bonds or perhaps a fund(s) could also be appropriate.
Though “junk” bonds indeed pose more hypothetical and relative risk as compared to investment grade paper, keep in mind that the current default rate for domestic high-yield debt according to recent reports from Moody’s sits at around 3 percent. Compare that to the roughly 13% default rate witnessed in 2009 as a result of the financial crisis. Still, my view for the average investor is that they should stick to funds for high-yield exposure, taking advantage of the immediate diversification and professional management, rather than take the small chance that an individual position falls into default.
Upgrades and Downgrades
Just like sell side equity brokerage firms, credit agencies alter their ratings on corporate credit from time to time. Typically, when the financial outlook for a company changes, agencies may issue a “one notch” move in opinion. So, if company XYZ, which currently possesses a BBB rating improves its balance sheet or sees substantial gains in revenue, it might be upgraded to BBB+, while if the same company increases leverage or makes an earnings dilutive deal to acquire another company, it might be downgraded to BBB minus.
Credit upgrades and downgrades impact not only future borrowing costs for companies, but the pricing of bonds trading on the open market. Depending on the length of time left until maturity, an upgrade could substantially increase the market price for existing bonds and vice versa for a downgrade. Additionally, upgrades or downgrades might have an impact on a company’s decision to call bonds. An upgrade could make debt refinance for a company an attractive option if it has a substantial amount of higher yielding debt floating around.
More sophisticated bond investors can look for bonds they feel are underrated by the agencies, and possess the potential for an upgrade. If you think XYZ company with a rating of BB+ has an improving business and credit profile that makes it worthy of investment grade, you might consider purchasing the company’s bonds in hopes of an upgrade to BBB-, which could provide for an attractive total return opportunity.
Credit agencies perform an important backbone function in the bond market. Though ratings are subject to scrutiny from both investors and corporations and might be considered hocus pocus by some, agency determinations have profound effect on corporate borrowing costs and investor purchase activity. Though it may be unwise to make purchase decisions based solely on credit rating, comprehension of agency jargon can help determine the general amount of portfolio risk being taken.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.