Notches on the bond ratings scale represent the opinion of credit rating agencies as to the likelihood of a bond
issuer defaulting, but they do not tell investors whether a bond is a good investment. Investors need
Bondsavvy's investment
analysis to understand the risk/reward opportunities of corporate bond investments and to increase their corporate bond
returns.
While corporate bond ratings do have weaknesses, bond ratings upgrades and downgrades can impact corporate bond trading, so understanding how bond ratings work
and how they impact corporate bond prices is an important part of being a successful bond investor.
AAA Rated Corporate Bonds: The Highest Corporate Bond Rating
As we show in the bond ratings scale in Figure 1 below, bond ratings begin at the top, with the Aaa / AAA rating, the
highest corporate bond rating. In fact, it's so high that only two corporate bond issuers have the coveted Aaa
/ AAA rating: Johnson & Johnson and Microsoft. For bond investing newbies, these bonds are called "triple
A."
Figure 1: Bond Ratings Scale for Moody's and S&P
A bond rating presented as "Aaa / AAA" shows the ratings of the two leading credit rating agencies, Moody's and
S&P. Bond ratings are typically presented "Moody's Rating / S&P Rating."
While a corporate bond may be rated AAA today, that bond rating is not forever. Companies mature, growth
can slow, and management can make mistakes. Many years ago, GE was rated Aaa / AAA. After years of
financial difficulties, however, on March 15, 2021, its bonds were rated Baa1 / BBB+.
Click here to get four prior bond pick updates.
As corporate bonds
move down the bond ratings scale, Moody's and S&P believe bonds have a potentially higher default risk. As
we show in the bond ratings scale in Figure 1, bond ratings are similar to school grades, with bonds rated "A"
deemed to be 'better' and, according to the bond rating agencies, have a lower default risk than bonds rated
"B." Within each letter category, the more letters a bond rating has means a bond is deemed to have a lower
default risk. Therefore, a bond rated AA is deemed to have a lower risk of default than a bond rated A.
If a bond defaults, it will typically reflect a "D" rating.
Before we dive deeper into the bond ratings scale, it's important for investors to understand that the bond
ratings scale only tells a very small part of the bond investing picture. Corporate bond ratings do not tell
investors whether a bond is a good investment. Investors need to compare where a bond is priced to the bond
issuer's financials to begin determining whether a bond is a good value. This fixed income investment analysis is core to the Bondsavvy investment
newsletter subscription, which we discuss further in the next section.
Bond ratings only tell investors part of the story
Bond ratings only provide the opinion of the leading credit rating agencies as to the likelihood of a bond
defaulting. This is known as "credit risk" or "default risk." What bond ratings do not
tell investors is whether an individual corporate bond is a potentially good investment. Bond ratings don't
contemplate the price at which a bond is trading or its yield. Corporate bond ratings do not speak to the
relative value of a corporate bond investment since they do not factor in the corporate bond prices of an issuer's bonds, how
credit spreads stack up to comparable bonds, and
how investors should compare the risk / reward opportunity of different corporate bonds. In addition, bond
ratings don't contemplate the interest rate risk of a bond, or how sensitive the corporate bond's price will be to
changes in underlying Treasury yields.
Luckily, Bondsavvy factors in all of these investment considerations
when we make bond investment
recommendations to our subscribers.
Apart from the bond rating weaknesses mentioned above, there are two others. First, many bond ratings can go
years with never changing, so investors waiting for a bond rating agency to upgrade or downgrade a bond and to use
that as a 'signal' as to when to make an investment could be waiting a long time. Second, bond
ratings methodologies are flawed, as they reward big companies with 'well-diversified' product lines.
Large companies often have inflated bond ratings whereas the bond ratings of smaller companies are often
underrated. Many of Bondsavvy's recommendations are bonds rated below investment grade that often have better
financials than higher-rated, investment-grade corporate bonds.
The Bond Ratings Scale
As we move down the bond ratings scale, we eventually get to bonds that are rated BBB, or "triple B." Hardly a
day goes by where a pundit or some bond investing luminary talks about the BBB bond bubble, saying the leverage of
these companies has reached unsustainable levels. The truth of the matter is that most companies rated BBB
have leverage ratios (total
debt divided by the company's EBITDA for the last twelve months) of 3.0x and less. If such companies have a
responsible capital allocation policy that avoids spending billions on share repurchases, focuses investment on
growing the company, and leaves some cash in the kitty for a rainy day, these companies will generally be okay and
do not pose significant default risk.
Click here to get four prior bond pick updates.
It's the Investment-Grade-in-Name-Only or "IGINO" bonds that cause the biggest problem. As we discuss in this
bond ratings
methodology blog post, Kraft-Heinz bonds had been rated investment grade even though Kraft-Heinz's
financials have been terrible and substantially worse than bonds rated below investment grade. The Kraft-Heinz
bonds were beneficiaries of a bond ratings methodology skewed in the favor of global behemoths at the exclusion of
smaller, nimbler, and better-run companies.
This brings us to the line of demarcation in the bond ratings scale, which splits investment-grade bonds with bonds
rated below investment grade, which are also known as high yield bonds. Some refer to
them as 'junk bonds,' but we have never used the word 'junk' to refer to a bond. Many bonds rated below
investment grade are great companies, but they are often small or the rating agencies could have a bias against the
company's industry or management team. For instance, until late 2019, Moody's had rated Expedia below
investment grade even though the company has a history of strong growth and had more cash than debt. Moody's
reason for its Expedia bond rating was that the company was controlled by Barry Diller, and that factor could result
in higher leverage at some point. Talk about grasping at straws and ignoring fundamentals.
As shown below, corporate bonds with ratings above the green line are rated investment grade, and those below the
green line are rated below investment grade. The lowest investment-grade bond rating is Baa3/BBB- and the
highest rating below investment grade is Ba1/BB+. In certain cases, bonds could be rated investment grade by
one rating agency and below investment grade by another. Bonds rated this way are said to be "split
rated."
To put bond ratings into perspective, it's helpful for investors to see examples of corporate bond issuers and the
ratings of each company:
Figure 2: Corporate Bond Ratings as of March 19, 2020
Microsoft: Aaa / AAA
Apple: Aa1 / AA+
Wal-Mart: Aa2 / AA
Pfizer: A1 / AA-
PepsiCo: A1 / A+
Caterpillar: A3 / A
Comcast: A3 / A-
Verizon: Baa1 / BBB+
Kroger: Baa1 / BBB
Ford Motor: Ba2 / BB+
Lennar: Ba1 / BB+
Albertsons: -- / B+
Keep in mind that bond rating agencies will assign different ratings to corporate debt with different levels of
seniority. For example, senior secured bonds would generally have a higher bond rating than senior unsecured
bonds. Term loans and revolving credit facilities that are secured by specific collateral such as real estate,
inventory, or other hard assets would typically have higher ratings than unsecured bonds. The above ratings
are for the issuing companies' unsecured debt, which is typically the level in the capital structure in which we
provide investment recommendations.
Why Bond Ratings Are Important
While bond ratings have many shortcomings, they are important for two key reasons: first, a bond's credit rating will
determine how sensitive a corporate bond is to rising interest rates and, second, bond rating upgrades and
downgrades can have a big impact on corporate bond prices.
Investment grade corporate bonds can be sensitive to changes in Treasury yields, as, on professional trading desks,
these bonds are quoted as a spread to their benchmark Treasury. This is called the credit spread, or Treasury spread. As we
discuss beginning at minute mark 1:37:38 in How Do Bonds Work?, a corporate bond that matures in, let's suppose, 2035, will
trade as a spread to a US Treasury bond that also matures in 2035. If the corporate bond has a yield to
maturity of 3.50% and the benchmark Treasury has a yield of 2.00%, the corporate bond would have a credit spread of 1.50% or 150 basis
points. The credit spread represents the extra yield (or compensation) an investor receives for taking credit
risk that is greater than Treasury bonds, which many investors (not Bondsavvy) believe have no credit risk.
Click here to get four prior bond pick updates.
As the Treasury yield moves up and down, so does the yield to maturity of the corporate bond, assuming the credit
spread has not moved. This is a crucial point for corporate bond investors to understand, as, while
investment-grade corporate bonds generally do have a lower risk of default than high yield bonds, they are generally
more sensitive to changes in Treasury yields. This is especially true for longer-dated bonds.
The other reason why understanding the bond rating scale is important is because most large bond funds can only hold
bonds that have bond ratings above a certain level. For example, if the bond fund's charter says a bond fund
can only own corporate bonds rated investment grade, if bonds in the fund are downgraded to below investment grade,
that fund must automatically sell such downgraded bonds. This results in forced selling since many large bond
funds must now sell a downgraded bond even if the bond is still a compelling value. Bonds that are downgraded
from investment grade to below investment grade are called 'fallen angels.'
High yield corporate bonds are generally not sensitive to changes in underlying Treasury yields, as their price
movements are generally tied to changes in the bond issuer's creditworthiness, bond fund flows, and other economic
conditions. When high yield corporate bonds are quoted on corporate bond trading desks, they are quoted on a
dollar-price basis, which represents the bond's value as a percentage of its face value. For example, a bond quoted
as 98.00 means it is valued at 98.00% of its $1,000 face value, or $980.
Since high yield bonds are not quoted as a credit spread like investment grade corporate bonds, their values
typically do not tick up and down based on changes in underlying Treasurys. As a result, high yield
corporate bonds can often be good investments in low interest rate environments where a material increase in
interest rates could significantly impact investment grade corporate bonds. We further discuss the rationale
for owning high yield corporate bonds in our How To Profit from Rising Interest Rates blog
post.
Investors in individual corporate bonds must be mindful of the existence of ratings-driven investing. When we
consider bonds rated BBB and BBB-, we like to understand the downgrade threshold for that particular bond. We
want to know how badly the company can perform before its bond ratings are downgraded to below investment
grade. It's important to know this as a bond investor because, in the event of forced selling by large bond
funds, fallen angels will fall in price, and sometimes the price reductions can be significant.
Often times, we find compelling bond investment opportunities in corporate bonds rated just below investment
grade. These bonds are not sensitive to changes in underlying Treasury yields and, if these bonds are upgraded
to investment grade, it can have a very positive impact on the bond price, as now a wider range of bond funds can
buy the bond. Of course, these bonds can still be downgraded from BB to B (or lower), but investors won't
witness the level of forced selling that occurs when a corporate bond initially becomes a fallen angel.
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