Bond Ratings

After the financial crisis of 2008, many bond rating firms came under fire for contributing mayhem (S&P paid $1.5 billion and Moody’s paid over $800 million). Prior to the collapse, investors (both institutional and retail) purchased a tremendous amount of debt with questionable credit worthiness. Importantly, the companies issuing the debt were rated well; the issue was that the rating itself was overinflated. Think of it like this, if a person wants to borrow money to buy a house, a mortgage company checks his/her credit and decides on the terms of the loan. If the credit bureau inflates that person’s credit score, then the mortgage company may make a loan to a borrower with suboptimal credit. In this analogy, the mortgage company is the investor. They would be understandably upset if the borrower defaulted on the loan later.

So, how does this happen? It’s actually very simple. Bond rating companies are paid for their ratings by the credit issuer. If you are a large corporation issuing debt, you want the best possible terms for your debt, so you hire the most lenient rating firm to assess said creditworthiness. Because credit issuers pay for ratings, bond rating companies are incentivized to inflate ratings.

So, what does this mean for investors today? The Journal thinks it might be happening again. The article spends a little more time dissecting the conflicts of interest and how regulators are trying to (or trying not to) change the system. Personally, I’m more concerned about inflated credit on a smaller level. Specifically, how does this impact individual investors? Today, more so than in prior markets, I think this poses a significant risk to the investing public.

To illustrate my point, here is a little background. Bond ratings can be divided into two major categories and several subcategories. For our purposes, we will focus on S&P. Each company uses different nomenclature, but they all amount to the same thing.

S&P Rating Scale:

AAA: Extremely Strong Capacity to Repay

AA+, AA, AA-: Very Strong Capacity to Repay

A+, A, A-: Strong Capacity to Repay

BBB+, BBB, BBB-: Adequate Capacity to Repay

BB+, BB: Faces Major Future Uncertainties

B: Faces Major Uncertainties Today

CCC: Currently Vulnerable

CC: Highly Vulnerable

C: Has Filed Bankruptcy Petition

D: Currently in Default

Each rating implies a firms’ increasing or decreasing credit worthiness and warrants higher or lower interest rates. The better the rating, the lower the interest rate. All debt at the triple B minus (BBB-) level and above is considered “investment grade” and everything at double B plus (BB+) and below is considered speculative, or “junk.”

Generally speaking, when a retail investor buys bonds, it does so through an intermediary, like a mutual fund or an exchange traded fund (ETF). Unless otherwise specified, the investment company that runs the fund is purchasing investment grade debt for the portfolio. The problem arises with fund companies enforcing strict rules on their fund managers holding bonds in their portfolio. If the investment policy statement that governs a fund or ETF specifies that their bond investments must be “investment grade,” then a potential downgrade to some debt could trigger liquidations. Put differently, fund managers could be forced to liquidate bonds and take losses on a portfolio because of a credit rating downgrade. Clearly, this only applies to firms that are downgraded below BBB-. The debt with the highest risk of downgrade are issues with a current rating at the BBB level.

So how much debt is at that level? According to Morgan Stanley, the BBB market has grown from $686 billion to $2.5 trillion over the past 10 years (https://www.marketwatch.com/story/half-of-investment-grade-bonds-are-onl…). BBB debt now accounts for roughly 50% of the investment grade market. When market conditions begin to erode, this is ostensibly the first debt to be downgraded and sold at a loss. Again, that’s half the investment grade bond market!

For passive investors, ETFs generally take on a very specific cross section of market risk. An ETF like AGG, for example, contains only 14% of BBB issues. However, for active funds the problem is exacerbated. Pimco’s Investment Grade Credit Bond Fund currently holds 42% of its portfolio in BBB-rated debt!

Over the past 10 years I have seen fund managers purchase more and more lower credit quality debt to produce a higher yield, while ratings agencies continue to inflate creditworthiness in order to win more business. This is creating hyper supply and demand at the same time. When market forces reverse, there will be seriously adverse effects for individual investors.

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