Bond ratings scales represent the opinion of credit rating agencies as to the likelihood of a bond issuer defaulting. As shown in the following bond
ratings scale table, bond ratings begin at the top, with the Aaa / AAA rating, the highest rating a bond issuer can achieve. 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."
As you move down the bond ratings scale, Moody's and S&P believe bonds have a potentially higher default risk. 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.
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. Bond ratings don't 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 they 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. We discuss this issue in greater detail in a blog post called "Why We Are Pouring Ketchup on Bond Ratings."
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.
It's the Investment-Grade-in-Name-Only or "IGINO" bonds that cause the biggest problem. As we discuss in this 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 ratings 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, 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."
Bond Ratings Scale for Moody's and S&P
To put bond ratings into perspective, it's helpful for investors to see examples of corporate bond issuers and the ratings of each company:
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 invest.
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 changes in underlying interest rates and, second, bond rating upgrades and downgrades can have a big impact on the price of a corporate bond.
Corporate bonds rated investment grade can be sensitive to changes in Treasury yields, as, on professional trading desks, these bonds are quoted as a spread to their benchmark Treasury. 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 3.5% and the benchmark Treasury has a yield of 0.75%, the corporate bond would have a 'credit spread' of 2.75% or 275 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 believe have no credit risk.
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 a certain rating. 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 that bond. 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.'
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 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, but investors won't witness the level of forced selling that occurs when a corporate bond becomes a fallen angel.