Why do investors follow Moody's and S&P bond ratings when they only tell investors a fraction of what they need
to know before making a bond investment?
Since corporate bond ratings don't factor in a bond's price, yield to maturity, maturity date, or the interest rate
environment, they leave investors with
more questions than answers. What's most troubling is the central purpose of bond ratings is to assess a bond
issuer's likelihood of default, and
we have found Moody's and S&P to often misrate corporate bonds. For example Kraft-Heinz and Keurig Dr.
Pepper are IGINO ("Investment Grade in
Name Only") bonds, as their financials simply do not support their lofty and undeserved investment grade bond
ratings.
Hundreds of billions of dollars are invested into bond index funds such as Vanguard Total Bond Market Index Fund
(VBTLX and BND) and BlackRock's iShares
Core U.S. Aggregate Bond ETF (AGG), which say they only invest in highly rated bonds. Since these funds treat bond
ratings as the gospel, they are laden
with bonds of issuers such as Kraft-Heinz, Keurig Dr. Pepper and others whose financials do not support investment
grade ratings. As a result, investors
in these bond funds are misled about the risk profile of VBTLX, BND, AGG and other so-called high-quality bond
funds. Unknowingly, investors in 'super-safe'
mega bond funds such as VBTLX, BND, and AGG own junk bonds....surprise!
For these and other reasons we discuss in this fixed income blog post, we believe it's time to pour ketchup on
corporate bond ratings.
Examples of inaccurate corporate bond ratings
Both Moody's and S&P, the two major credit rating agencies, have bond ratings methodologies that are so
complicated and intricate that they often make
mistakes. Seemingly endless factors contribute to corporate bond ratings, which can result in the misrating of
corporate bonds. The biggest
flaw in the bond ratings methodologies relates to how different factors are weighted. In many cases, a
company's leverage ratio (total debt divided
by a company's trailing 12 months' EBITDA) is weighed less than more fuzzy factors such as business diversification,
total revenue, and innovation.
We'll provide specific examples of the weightings bond rating agencies use later in the post.
Consider the following examples of misrated corporate bonds:
- Ketchup maker Kraft-Heinz (Nasdaq: KHC), with its 4.4x leverage ratio, stumbling business and accounting issues,
is rated investment grade by both
Moody's and S&P
- $11 billion Keurig Dr. Pepper (NYSE: KDP) is rated investment grade when it has a leverage ratio of 5.4x
while $60 billion grocer Albertsons has
a leverage ratio of 3.6x and is rated B- by S&P
- Moody's rates Expedia (Nasdaq: EXPE) as a high yield bond, Ba1, in spite of its 1.8x leverage ratio and
having more cash than debt on its balance
sheet
- All three Bed Bath & Beyond (Nasdaq: BBBY) company bonds have the same bond ratings, even though its $300
million of 3.749% 8/1/24 bonds (CUSIP
075896AA8) have materially lower risk of default than its $900 million of 5.165% 8/1/44 bonds (CUSIP 075896AC4)
- Companies with stronger credit profiles than many investment grade bond issuers, such as US Concrete (Nasdaq:
USCR), Tennant Company (NYSE: TNC), and
H&E Equipment (Nasdaq: HEES), are rated below investment grade while KDP and KHC reap the many
benefits of being an investment grade
bond issuer
We will later compare the financials of each of these companies to show the inaccuracies of specific bond
ratings. Unfortunately, inaccurately gauging
the credit risk of bond issuers is only one weakness of corporate bond ratings.
How Bond Ratings Miss 80% of What Counts
There is an ominous warning at the end of each Moody's Bond Report:
"MOODY’S CREDIT RATINGS AND MOODY’S PUBLICATIONS ARE NOT INTENDED FOR USE BY RETAIL INVESTORS AND IT WOULD BE
RECKLESS AND INAPPROPRIATE FOR RETAIL INVESTORS
TO USE MOODY’S CREDIT RATINGS OR MOODY’S PUBLICATIONS WHEN MAKING AN INVESTMENT DECISION."
Yikes....perhaps if packages of cigarettes had warnings like this, there would be fewer smokers. It seems like
Moody's lacks confidence in its corporate
bond ratings to issue such a warning.
While this disclaimer might have been mandated by Moody's legal eagles, the authors of this note might be on to
something. As noted above, credit
ratings only address a small part of a bond investment's overall thesis, and this they often get wrong. If
bond ratings can't even provide an accurate
assessment of credit risk, then what good are they? Bond ratings weaknesses include:
- Bond ratings often inaccurately rate an issuer's credit risk, as summarized above and discussed in further
detail below
- Bond ratings do not speak to the value of a bond, as they ignore the underlying bond prices and yields of bonds
relative to their bond ratings
- Bond ratings do not address a bond's interest rate risk or provide guidance as to which of a company's bonds
could perform better based on the interest-rate
environment
- Bond ratings do not distinguish among an issuer's different maturities and, therefore, imply that a bond due 30
years from now has the same credit
risk as one due in two years
- Bond ratings often go years without changing even though there could be myriad buying and selling opportunities
over that period of time
- Thousands of corporate bonds have the same credit rating, which lumps together bond issuers with disparate
credit profiles and investment rationale
While Moody's and S&P bond reports are worthwhile reading, since bond ratings ignore some of the most basic
considerations in a bond investment, their
overall value is questionable.
Since Bondsavvy's investment recommendations consider not only a bond's credit quality but also its price,
yield to maturity, maturity date, and interest rate sensitivity relative to other bonds, we believe our analysis
is superior to what credit rating agencies provide.
Bond Rating Scales for Moody's and S&P
While bond ratings have many weaknesses, they are still very important in today's US corporate bond market, as we
will discuss in further detail later.
It's therefore important for fixed income investors to familiarize themselves with the bond rating scales used by
Moody's and S&P. Since bond
ratings do not consider a bond's price, yield, or maturity date, they only speak to the likelihood of a bond
issuer's default. This is known as credit
risk, where bonds with a higher risk of default are deemed to have higher credit risk than bonds with a lower risk
of default. As you move from top
to bottom in the below bond rating scale, a bond's creditworthiness decreases according to Moody's and
S&P. Today, Microsoft and Johnson &
Johnson are the only two companies rated Aaa/AAA by the credit rating agencies. While credit ratings can often
go years with never changing, investors
must be mindful that, as time goes on, today's dominant company could be tomorrow's underperformer. For
example, S&P downgraded GE from AAA to
AA+ in March 2009 and, today, GE bonds are rated Baa1/BBB+.
The dividing line between investment grade bonds and those rated below investment grade (also known as high yield
bonds or even junk bonds) is the rating
of Baa3 / BBB-. Many investors zero in on the specific bond rating; however, this approach puts too much
reliance on the credit rating agencies.
Many investors believe bonds rated investment grade automatically have a lower default risk than high yield bonds,
but this is often not the case.
In fact, there are many investment grade bonds that should be rated as high yield and many high yield bonds that
should be rated investment grade.
We provide examples of these cases below.
Moody's and S&P Bond Rating Scales
According to page 69 (Glossary of Investment Terms) of the Vanguard Total Bond Market Index Fund prospectus, a
bond must have at least a Baa3 rating by Moody's to be deemed investment grade and to be included
in the Bloomberg Barclays U.S. Aggregate Bond Index, the index that VBTLX tracks. Since the Moody's rating is the
rating that determines whether a bond
is deemed investment grade by the Bloomberg Barclays index, errors in the Moody's rating methodology are
consequential to investors in the Vanguard Total
Bond Market Index Fund. As a result, since Moody's incorrectly rates bonds such as Kraft-Heinz and Keurig Dr.
Pepper as investment grade, VBTLX,
BND and AGG are not the high-quality funds they market themselves as.
The layperson would likely assume that bond issuers with greater creditworthiness have higher credit ratings than
issuers with lower creditworthiness.
This, unfortunately, is often not the case. When looking at the below table, if we had hidden the "Rating" row at
the bottom, many readers would have come
to the conclusion that KHC and KDP should be the lower-rated bonds due to their higher leverage ratios
relative to the other corporate bond issuers.
Oddly, this is not the case, as it is KHC and KDP that are rated investment grade while Expedia, Albertsons, US
Concrete, H&E Equipment, and Tennant
Company are rated high yield and are thus forced to pay higher interest expense than they should be paying.
Relationship Between Company Financials and Corporate Credit Ratings
Source: Company SEC filings, company earnings releases, and Bondsavvy
calculations.
The above table provides real-life examples of credit ratings that don't accurately reflect a bond issuer's default
risk. The five issuers rated high yield
by the rating agencies should be investment grade while KHC and KDP should be rated high yield. As we review
Moody's ratings methodology below, we
see that leverage ratios are but one of many pieces of information it considers when assigning bond ratings. While
we don't believe a leverage ratio is
the only worthwhile metric to review, we do believe it is an equalizer that can compare bond issuers across
different industries. We believe it's superior
to interest coverage, as interest coverage is a circular metric given that, if a bond issuer is rated investment
grade, its interest coverage is going
to be higher than if it was rated high yield since investment grade bond issuers pay lower coupons than high yield
bond issuers. Leverage ratios are also
superior to some of the fuzzy, qualitative metrics in Moody's methodology such as brand strength, product
diversification, and pricing flexibility.
The Problems with Credit Ratings Methodology
Both Moody's and S&P have specific bond rating methodologies. In our opinion, these methodologies often miss the
forest for the trees, as the weightings
of different factors can make a company's leverage ratio meaningless, as happened with KHC and KDP. The ratings
methodology changes by industry, as different
factors receive different weightings as shown in the below Moody's Ratings Factors. Moody's breaks down its rating
factors into 'Broad Factors' and 'Subfactors.'
For example, companies in the global soft beverage industry have ratings weighted 40% toward their business profile,
and that 40% is comprised of five
different subfactors shown on the right side of the business profile grouping:
Moody's Rating Factors: Global Soft Beverage Industry
Source: Moody's Investor Service
Moody's methodology for the global soft beverage industry shows us how it got the rating for KDP so wrong. The
two most important metrics from our
perspective -- Retained Cash Flow / Net Debt and Debt / EBITDA -- only account for 14% of the total rating. Weighing
feel-good factors such as total revenue,
product diversification, brand strength and others more heavily than the most important credit metrics is misguided
and results in a KDP rating that is
inflated seven notches. We care about whether the company is going to have the resources to pay its interest expense
and, ultimately, pay back principal
on the issued bonds. Moody's and S&P ooh and aah over companies with lots of revenue, but if revenue only grew
at 0.7% in 2018 as it did for KHC, scale
is not going to be enough to address its bloated balance sheet.
Moody's methodology for the retail industry differs from the soft beverage industry, as there is a materially higher
weighting for traditional credit metrics
such as leverage and coverage. We don't have much insight on Moody's thinking on the Albertsons bonds, as Moody's
had previously withdrawn its Albertsons
bond ratings. That said, rating agencies such as Moody's and S&P tend to have dim views of anything touching
brick & mortar retail, and this view
shows through on the underrating of many brick & mortar retailers such as Albertsons.
Moody's Bond Ratings Factors: Retail Industry
Source: Moody's Investor Service
Why Is This Important?
Due to their many shortcomings, Bondsavvy doesn't believe investors should rely on corporate bond ratings to make
investment decisions. It's a key reason
Bondsavvy makes CUSIP-level recommendations, as we not only consider a company's credit profile, but we also compare
our credit analysis to the value of
the bond, as determined by the bond's price and yield relative to comparable bonds.
That said, corporate credit ratings issued by Moody's and S&P have a material impact on the US corporate bond
market and corporate finance in general,
as they determine:
- How much companies pay in interest: Nearly all of USCR's debt is the company's 6.375% 6/1/24
Senior Notes (CUSIP 90333LAP7), which
have an annual interest expense of $38.3 million and were issued June 7, 2016. To determine USCR's potential
annual interest expense savings if
it was rated investment grade, we identified a KDP bond that was also issued in 2016 and has a slightly longer
time until maturity: the Dr. Pepper
Snapple Group 2.550% 9/15/26 bond (CUSIP 26138EAU3). Had USCR's credit rating better reflected its credit
profile, it would save $23 million in
annual interest expense if it issued its bonds at the 2.550% coupon rate. Such savings would free up the company
to build more concrete plant facilities,
get more concrete trucks on the road, and hire more workers, which would be a win for everyone.
- Which bonds are held in different bond mutual funds and ETFs: The world's largest bond fund,
Vanguard Total Bond Market Index Fund
markets itself as a low-risk bond fund. Its fund prospectus even says "Credit risk should be low for the Fund
because it purchases only bonds that
are of investment-grade quality." It's this supposed low credit risk that the fund has used to justify its
meager 1.63% average return during 2015-2018,
as we previously wrote in The Vanguard Bond Fund Road to Nowhere.
Ironically, this supposed low-risk fund owned 15 bonds of both Kraft-Heinz and Keurig Dr. Pepper
according to the fund's December 31,
2018 annual report. These
bonds, for all intents and purposes, are IGINO bonds or "Investment Grade in Name Only" bonds. As a result,
VBTLX owns scores of bonds that
should be rated as high yield bonds. Vanguard will hide behind the credit rating agencies in this case, but it
shouldn't market a fund as having
'low credit risk' when VBTLX owns bonds that are clearly sub-investment-grade bonds.
- Bond maturity dates: Investment grade corporate bonds often have initial bond maturities
between 20 to 40 years, whereas high yield
corporate bond maturities are typically 10 years and under. Some investment grade corporate bonds have even had
100-year maturities. For example,
JCPenney (NYSE: JCP) issued century bonds in 1997 when it was an investment grade company. Having a longer
time until maturity provides investment
grade bond issuers greater financial flexibility since they don't have a near-term gun to their heads to pay
back or refinance debt. It provides
longer-term capital, a key advantage over high yield bond issuers.
- Extent of financial covenants: Given the perceived higher credit quality, investment grade
corporate bond issuers have few, if any,
financial covenants related to their bonds. As with longer-dated maturities, the limited financial covenants
provide greater operating flexibility
to the issuing companies and reduce the likelihood of an event of default. For example, as noted above,
JCP was an investment grade issuer
when it issued bonds in 1997. These bonds came with no financial covenants and, as a result, even as the
company's leverage ratio is 8x as of the
most recent quarter, the company is not off-side any financial covenants.
- How corporate bonds trade: Bond ratings determine how corporate bonds trade in the market and
whether their price is impacted by changes
in US Treasurys. Investment grade corporate bonds trade as a spread to their benchmark US Treasury bond whereas
high yield corporate bonds trade
on a dollar-price basis and are generally not impacted by changes in the benchmark US Treasury. For example, the
Verizon 3.85% 11/1/42 bond (CUSIP
92343VBG8) trades off the US Treasury 2.75% 11/15/42 bond (CUSIP 912810QY7). What this means is that the yield
to maturity of the Verizon bond
is driven by two factors: a) the YTM of the benchmark US Treasury and b) its credit spread to the benchmark
Treasury.
As shown in the Verizon 3.85% '42 bond chart below, on July 10, 2019, the bond had an ask side yield to maturity of
3.75%, which equated to a dollar price
of 101.582. As we see, the benchmark US Treasury had a YTM of 2.49% and the credit spread of the Verizon bond was
1.26%. Since the Verizon bond trades
off the benchmark Treasury, if the benchmark Treasury's YTM ticks up, that component of the Verizon bond's YTM would
increase, thus causing the Verizon
bond's price to decrease. If the bond's credit spread shrinks due to strong operating performance at Verizon, that
component of the bond's YTM will fall,
causing an increase in the price of the Verizon bond.
Verizon 3.85% 11/1/42 YTM Building Blocks
Source: Fidelity.com "Price & Performance" screen. July 10, 2019.
High yield bonds differ from investment grade bonds as they are credit investments that move up and down as the
creditworthiness of a bond's issuing company
improves or worsens. Since high yield bonds are quoted on Wall Street trading desks on a dollar-price basis, their
prices do not tick up and down based
on changes in their benchmark US Treasury bond.
We illustrate this concept in the following two charts, which show the price performance of the Albertsons 7.45% '29
bond (CUSIP 013104AF1) Bondsavvy recommended
to subscribers in September 2017 relative to its benchmark, the US Treasury 6.125% 8/15/29 (CUSIP 912810FJ2). We see
that the Albertsons bond has returned
33.6% from the September 25, 2017 recommendation date through April 30, 2019 compared to a 1.7% total return for its
benchmark US Treasury. During this
time, the Albertsons bond increased 15 points while the benchmark US Treasury fell 7.4 points.
This example shows how the bond price of a high yield corporate bond such as Albertsons 7.45% '29 moves independent
of the benchmark US Treasury. Its ability
to do so is due, in large part, to its high yield bond rating.
Price Performance of Albertsons 7.45% 8/1/29 bond
Source: FINRA market data.
Price Performance of US Treasury 6.125% 8/15/29
Source: FINRA market data
What Should Be Done?
Since corporate credit ratings impact such crucial factors from how much interest expense companies pay to how bonds
trade in the open market, it's crucial
the major credit rating agencies correct bond rating inaccuracies. While much time has been spent on developing
ratings methodologies, a greater focus
needs to be on tangible credit metrics on which companies can focus, knowing that, if they improve these credit
metrics, they will be rewarded with improved
ratings. Rewarding companies merely for their size and/or diversification is the wrong way to go and focuses
companies on initiatives that often do not
make them better companies or credits.
For retail investors, we believe Bondsavvy's recommendations are an effective
replacement for corporate credit ratings. Our analysis focuses on the metrics most closely related to an
issuer's ability to service its debt.
Further, since all of our recommendations are made at the CUSIP level, we evaluate all of what Moody's and S&P
miss: the prices at which bonds trade,
yields to maturity, maturity dates, and interest rate sensitivity. We believe it's crucial for investors to
understand all of these factors when
investing in individual corporate bonds.
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