Stocks & Bonds

Beyond Bond Ratings

There's much more to the rating of a corporate- or municipal-bond issuer than a mere letter grade.

By Jeffrey R. Kosnett, Senior Editor

From Kiplinger's Personal Finance magazine, October 2009

Bond ratings and those who issue them are easy targets. Early this decade, ratings firms, such as Standard & Poor's and Moody's, offered no warnings about the scandals brewing at Enron and WorldCom before the firms collapsed. More recently, the raters missed the troubles looming at Lehman Brothers and other financial institutions, not to mention the ax that was about to fall on holders of subprime-mortgage securities. Critics have complained, at congressional hearings and elsewhere, that ratings agencies are hopelessly compromised by a business model in which they receive fees from the very bond issuers the public expects them to judge impartially.

Yet the last time I looked, the rating system, now 100 years old, rolls on. I've asked countless advisers and bond-fund managers who question the quality of ratings whether they know of a better business model or regulatory process that would remove suspicion and encourage early warnings. They struggle to come up with alternatives. "Are you kidding me?" says Bill Walsh, partner of Hennion & Walsh, a New Jersey municipal-bond firm. "Let the government do it? No politics in that, huh?" Hard to argue that point.

For now, the real issue isn't whether the Securities and Exchange Commission or some new panel should rate bonds or be given the power to release bulletins about issuers in the same way that the government announces auto recalls. More important is how you, as an investor, should use the grades and other information generated by raters.

Read the reports. There's much more to the rating of a corporate- or municipal-bond issuer than a mere letter grade. The reports contain a lot of valuable information, particularly because, as Patrick Sporl, a corporate-bond-fund manager for American Beacon, observes, the SEC's Regulation FD does not apply to company contact with analysts at rating agencies. (FD bars companies from selectively disclosing material information.)

You won't want to pay hundreds of dollars to get Moody's or S&P's full reports, but much of what the firms say about individual bond issuers seems to get around the Internet. There's nothing to stop bond brokers from sharing their findings with you, either. And Fitch Ratings, the third-largest rating firm, puts a lot of its news and commentary on its Web site.

Keep mild downgrades in perspective. If you're buying a bond for income and intend to hold it until it comes due, what matters is that the issuer pays interest on a timely basis and repays your principal at maturity. Under such circumstances, don't fret if a rater trims its grade on the bond you own from, say, double-A-minus to single-A-plus, even if the downgrade makes headlines and nicks the bond's price. This is particularly true when you're dealing with general-obligation municipal bonds issued by states.

In terms of safety, governors and state treasurers argue, GO state debt should be equivalent to Treasury bonds, or at least triple-A-rated corporate bonds. Although states can't print their own money and are suffering budget problems during the recession, I tend to agree with the governors and treasurers. Don't sweat ratings downgrades on GOs.

Look for ratings and yield inconsistencies. In mid August, the bond section of the Charles Schwab brokerage Web site said a representative ten-year, single-A muni yielded 5.9%, and a ten-year, triple-A yielded 4.1%. But when you look at the actual listings, you'll often find anomalies: Some ten-year single-A bonds yielded as little as 3.7%, while a few uninsured triple-A bonds (those supported by tax revenues or utility bills) paid up to 4.5%. Clearly, ratings don't drive everything. Bond-fund managers say they rely more on their own research to evaluate a bond's price and yield. If you're diligent, you, too, may be able to take advantage of pricing inconsistencies.

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