WASHINGTON, August 22, 2016 – This part of our ongoing investment course is something of a postscript to our last column, which provided our readers with more information on the intricacies of investing in corporate (taxable interest) or municipal (muni—mostly non-taxable interest) bonds.
Today’s article supplies one final but crucial ingredient in determining what bond or bonds might be a suitable investment for your portfolio: Bond ratings.
Bond ratings: What they are and how to interpret them
Bond ratings in the U.S. at least are generally provided by three longtime bond evaluation firms:
- Standard and Poor’s, or S&P, the folks who also give us the S&P market averages and S&P investment ratings on a wide universe of common stocks
- Moody’s; and
Whenever a new bond is issued, most bond issuers contract one of these three firms to go over their own firm’s books as well as the proposed details on the new bond to be issued (financial health and backing, revenue vs. bond interest and redemption, etc.) and whatever additional information might pertain.
When the rating firm has concluded its research, it will assign a rating to the issue. That rating is crucial to the issuing firm because it helps determine (along with the prevailing interest rate climate) the interest rate (sometimes called the “coupon”) the bond will carry upon issue.
A rating firm’s bond rating is essentially that firm’s determination as to the quality and safety of the new issue, which is why the ultimate interest rate the bond will pay can be greatly influenced by the rating firm’s report. The higher a bond’s rating for safety and quality, the lower the interest rate it will be required to pay investors.
The highest bond ratings are, in fact, quite difficult to come by and, as a result, quite coveted by bond-issuing firms. On the other hand, bonds issued by smaller companies, highly-indebted companies and companies known to have significant financial risk, can expect lower to much-lower ratings. Correspondingly, these lower ratings will require that new bonds issued by these companies offer higher and higher interest rates to attract investors due to the higher risk that these bonds might default—a term that refers to a bond that’s ceased paying interest.
Bonds carrying the highest ratings, as determined by each rating firm, are known as “investment grade” bonds, while bonds carrying ratings below this threshold are known (no surprise) as “non-investment grade bonds.” Wall Street has a snarkier name for bonds in this second category: “junk bonds.”
Below is a short list of each firm’s rating indications for these two general classes of bonds, just to give you an idea what we’re talking about. You can find considerably more detailed and useful charts on Wikipedia in the entry for “Bond credit rating.”
Here’s our short summation:
S&P Investment Grade: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-
S&P Non-investment Grade: BB+ thru CCC+ to D; Defaulted bonds: / (i.e., lost rating)
Moody’s Investment Grade: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3
Moody’s Non-investment Grade: Ba1 thru Ca; Defaulted bonds: C or / (i.e., lost rating)
Fitch Investment Grade: Same as S&P.
Fitch Non-investment Grade: Same as S&P thru B-, then CCC for all that category and DDD, DD and D for default grade
All three major rating services have additional categories that involve special situations. Here are two of them:
Moody’s: WR = Rating withdrawn for a variety of reasons including bond calls or mandatory conversions.
All three ratings firms: NR=Not rated, due to no rating request by issuer or due to insufficient information to rate. These are actually quite common, so you need to evaluate the quality of the issuing company itself to determine whether you want to take this kind of risk.
Moody’s “WR” rating usually shows up if a bond is “called” or terminated early, paying out the final interest and the full principal amount prior to its stated redemption date. WR can also appear if the issuer orders a mandatory conversion of an issue of bonds into common or preferred stocks.
WR situations are not usual, but they do happen, and higher interest rate bonds are frequently redeemed early if interest rates drop precipitously. That’s because those existing bonds that pay out at a higher interest rate can be almost instantly refinanced and re-issued as new bonds paying out an attractively lower interest rate. That doesn’t make bond investors happy, since they’ll lose that nice higher-than-average payout. But it makes the issuing company’s accountants very happy, because the company is now paying out less in interest and, presumably, retaining more of its profits.
Note that bond ratings are not permanent. If something positive happens that improves an issuing company’s financial standing, a bond rating can actually be improved a notch or two. Contrary-wise, if an issuing company’s finances start running into heavy seas, the rating for its bonds can get cut. When ratings firms are considering ratings changes, they’ll put one or more issues of a company’s bonds on “credit watch,” meaning that if you’re considering picking a package of these bonds up, the rating might change out from under you, for better or worse.
How bond ratings can work in your favor in real life
True story: during the sickening drop in bond prices during the height of the Great Recession and market crash, circa September 2008-March 2009, the Maven looked at perfectly decent investment grade bonds that had dropped in price in some cases down to 50 or 60 cents on the dollar, effectively increasing their fixed yields to the neighborhood of 8-10 percent, given the price drop.
Downing what seemed like a pint of Maalox and trembling at the keyboard, the Maven carefully evaluated what was out there and loaded up on the more attractive of these issues, all of which were paying pretty decent interest rates to begin with. The prices of the bonds issued by these reasonably high-quality companies had dropped to such a ridiculous level that, unless the world really was about to come to an end, would prove to be the bargains of the century.
After all, investment guru Warren Buffett (whom we actually don’t particularly like) had often stated that the best time to invest in something attractive was when “blood is running in the streets.” In March of 2009 in particular, media pundits were almost uniformly weeping and gnashing their teeth over the end of the world. If that wasn’t “blood running in the streets,” it would be hard to figure out what else it might be. And that’s when I placed most of that big (for me) bond bet.
The upshot: call it brilliance or a lucky guess. (I actually tends toward the latter judgment, fearing the inevitable consequences of hubris.) Within mere months, all those newly purchased, deeply discounted bonds rose quite rapidly back up to more respectable pricing as the mass of selling exhausted itself and as seasoned hands went back into the market to scoop up the absurd bargains that had almost literally been tossed into the landfill by panicked investors of all stripes.
I enjoyed those high equivalent interest rate returns for a time. But by 2010, things had improved to the point where, to my great disappointment, nearly every one of those bonds I’d purchased at the bottom were called “at par,” or at the $1,000 per bond that these bonds had been worth when they’d been issued. Again, by “called,” that means the bond is redeemed early at its full face value, i.e., $1,000.
For example, having bought bond X at 60 cents on the dollar ($600 per bond), I had a long term capital gain of $400 per $1,000 face, the kind of gain that’s virtually impossible to obtain on any bond during relatively normal times.
I actually don’t like bonds very much. But how can you resist a bargain like the one staring nervy investors in the face that March of 2009.
The whole reason for telling this true-life story is two-fold. First of all, by purchasing low investment grade bonds—bonds from good, well-known companies that, however, held somewhat lower than brilliant investment grades like BBB—I was able to garner an above-average interest rate return plus the kind of capital gain I’ll probably never see again on a bond.
Had those bonds been rated C, for example, I would have never touched them. Too dangerous, particularly in gut-wrenching March of 2009. But anything the rating services had rated the equivalent of BBB- or higher had a much better chance of surviving this debacle than did lower rated companies, so that’s where I took the risk.
The downside of bond ratings
That said, there is a downside to bond ratings, and this also revealed itself quite nastily during the Great Recession. Investigators learned that those once unknown but now legendary but hard-to-describe collateralized debt obligations (CDOs)—“bonds” created by banks and lending institutions by putting together various chunks of mortgages and repackaging them single debt instruments—had been scandalously overrated by the rating agencies. That fact was ultimately revealed when many of these CDOs started tanking en masse as the significant number of substandard mortgages buried within these supposedly investment grade issues began to default on a massive scale.
Many of these CDOs had been dishonestly rated A or better, a fact that actually brought many conservative investors and firms out of hiding to buy them, a serious error as it turned out. It’s an epic scandal that, while not much talked about today, is still being worked out with lenders, creditors and the Federal government. Everyone was asleep at the switch on this one, and there’s a great deal of blame to spread around.
A short but important intermission: If you haven’t already done so, I’d suggest that you rent, stream or download “The Big Short,” a phenomenally entertaining and informative film that brilliantly relates in detail the story of how a few quirky, nerdy but very insightful investors and firms took the opposite bet by shorting these awful investments. The result, after much nail-biting, was one of the more massive winning trades of all time in this esoteric investment sector. It’s a compelling story with an A-list cast, Even if you think you won’t be able to follow such a complex, number-laden tale, the script writers and story tellers who contributed to this film will teach you more about complex investments than you may ever have learned in college and you’ll be entertained mightily every step of the way.
Much of the real life rating scandal and subsequent crash described in “The Big Short” was due to the unfortunately cozy relationship between the debt issuers and the rating services who, we must remember, are contracted by the issuing firms to do the “unbiased” research and come up with accurate ratings. The pressure was on the ratings agencies, however, to issue a really swell rating on these dubious repackaged mortgages so the issuer could gain a lower interest rate obligation when selling the package. I.e., well, if you won’t guarantee me a AAA rating, I’ll just give this contract to the other guy.
Allegedly, after assorted massive fines and other penalties, today’s players, including the chastised ratings agencies, are behaving themselves better in the market place. Presumably, therefore, professional ratings today are—crossed fingers—even more reliable than they once were. At least that’s what we need to believe when we are considering purchasing a bond, or bonds or even a bond fund or ETF.
To sum things up: If you’re looking to assemble a bond portfolio, first of all, you need to have a decent amount of cash on hand, since the minimum purchase for many bonds is at least $5,000 in face value. Experience shows that you actually get the best pricing on a “round lot” of a single bond, however, which in this case is a full $25,000 face value.
That, however is a lot of money. I bought smaller increments ($5,000-$10,000 max) during my great 2009 bond buying binge. But as for the current investment climate, both you and I are probably a lot better off buying into a bond fund or ETF. Most of these are far more liquid than a single bond, and (theoretically at least) far less risky since our risk is spread around a large number of issues.
But if you’re buying bonds on your own (and some preferred stocks as well), the general rule of thumb is for the average investor of average means to buy only bonds that are investment grade, and now you know what these are.
Preview: Mutual funds and ETFs
Sure, junk bonds offer a considerably higher interest rate return. But they’re also riskier and will tank the moment the Fed says they’re really, really raising interest rates this time. For that reason, if you insist on putting a little “junk” into your portfolio, your better bet is to seek out diversified mutual funds or ETFs in that area.
Which observation happily brings us to the edge of our upcoming column, where we’ll explain exactly what mutual funds and ETFs really are.
Next: Spread your risks and diversify your portfolio with mutual funds and ETFs.
Check out The Prudent Man’s “Investing 101” online investment course for beginners as well as veteran investors who may need a few pointers in the treacherous Election 2016 stock market. Installments so far include the following topics/links: