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'sinvestment 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+.
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.
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Apart from the bond rating weaknesses mentioned above, there are two others. First, many bond ratings can go years with never changing, so investorswaiting 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 longtime. Second, bond ratings methodologies areflawed, as they reward big companies with 'well-diversified' product lines. Large companies often have inflated bond ratings whereas the bond ratingsof smaller companies are often underrated. Many of BondSavvy's recommendations are bonds rated below investment grade that often have better financialsthan 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 somebond investing luminary talks about the BBB bond bubble, saying the leverage of these companies has reached unsustainable levels. The truth of thematter is that most companies rated BBB have leverage ratios (totaldebt divided by the company's EBITDA for the last twelve months) of 3.0x and less. If such companies have a responsible capital allocation policythat avoids spending billions on share repurchases, focuses investment on growing the company, and leaves some cash in the kitty for a rainy day, thesecompanies 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 bond ratings methodology blog post, Kraft-Heinz bonds had been rated investment gradeeven though Kraft-Heinz's financials have been terrible and substantially worse than bonds rated below investment grade. The Kraft-Heinz bonds werebeneficiaries 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, whichare 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 bondsrated 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 managementteam. For instance, until late 2019, Moody's had rated Expedia below investment grade even though the company has a history of strong growth andhad 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 resultin higher leverage at some point. Talk about grasping at straws and ignoring fundamentals.
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As shown below, corporate bonds with ratings above the green line are rated investment grade, and those below the green line are rated below investmentgrade. The lowest investment-grade bond rating is Baa3/BBB- and the highest rating below investment grade is Ba1/BB+. In certain cases, bondscould 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 securedbonds would generally have a higher bond rating than senior unsecured bonds. Term loans and revolving credit facilities that are secured by specificcollateral such as real estate, inventory, or other hard assets would typically have higher ratings than unsecured bonds. The above ratings are forthe 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 corporatebond 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 spreadto 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 bondthat 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 corporatebond 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 manyinvestors (not BondSavvy) 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 acrucial point for corporate bond investors to understand, as, while investment-grade corporate bonds generally do have a lower risk of default than high-yieldbonds, 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 abovea 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 fundare downgraded to below investment grade, that fund must automatically sell such downgraded bonds. This results in forced selling since many largebond funds must now sell a downgraded bond even if the bond is still a compelling value. Bonds that are downgraded from investment grade to belowinvestment grade are called 'fallen angels.'
High-Yield Corporate Bonds Are Generally NOT Sensitive to Treasury Yields
High yield corporate bonds are generally not sensitive to changes in underlying Treasury yields, as their price movements are generally tied to changesin the bond issuer's creditworthiness, bond fund flows, and other economic conditions. When high yield corporate bonds are quoted on corporate bond tradingdesks, 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 98.00means it is valued at 98.00% of its $1,000 face value, or $980.
Since high yield corporate bonds are not quoted as a credit spread like investment grade corporate bonds, their values typically do not tick up and downbased on changes in underlying Treasurys.As a result, high yield corporate bonds can often be good investments in low interest rate environmentswhere a material increase in interest rates could significantly impact investment grade corporate bonds. We further discuss the rationale for owninghigh yield corporate bonds in our How To Profit from Rising Interest Ratesblogpost.
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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 ratingsare 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 sensitiveto 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, asnow 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 witnessthe level of forced selling that occurs when a corporate bond initially becomes a fallen angel.
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