Reviewing Credit Ratings: Part 3
We have learned about risks and the three types of people in the market. Now we are going to look at another tool used by Corporate Bond Investors in figuring out what issues will pay and which ones will not pay. Credit ratings are one of several tools that investors can use when making decisions about purchasing bonds and other fixed income investments. There are several different credit rating agencies around the world that do the same thing. We are going to focus on one agency called Standard and Poor’s.
Credit ratings are opinions about relative credit risk. Nothing in credit ratings are written in stone. As a matter of fact, financial conditions of corporations may change for the better or worst before a new rating is given. That means that credit ratings are not a guarantee of credit quality or a predictor of future credit risk. Credit ratings are not an indication of market liquidity of bonds or its price in any secondary market. Credit ratings should not be taken as investment advice. They should never be taken as buy, hold, or sell recommendations. They are just one factor investors may use in making investment decisions.
Credit ratings give investors an efficient, widely recognized, and long-standing measure of credit risk. Investors and other market participants can use the ratings as a screening device to match the relative credit risk of an issuer or individual bond issue with the investor’s own risk tolerance or credit risk guidelines. That way they can use these ratings in making investment and business decisions. But keep in mind, there are future events and developments that cannot be foreseen. That is why the assignment of credit ratings is not an exact science.
To assess the creditworthiness of an issuer, Standard and Poor’s evaluates the issuer’s ability and willingness to repay its obligations in accordance with the terms of their obligations according to the contract called the Indenture. Ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual bond issue, from strongest to weakest in relation to credit risk. A corporate bond that is rated as “AAA” is viewed by the rating agency as having a higher credit quality than a corporate bond with a “CCC” rating. But the “AAA” rating is not a guarantee that it will not default. It only means that in the opinion of Standard and Poor’s, it is less likely to default than the “CCC” bond.
Banks, insurance companies, endowments, and other financial institutions usually must invest in investment grade securities. According to Standard and Poor’s ratings, they range from “AAA” to “BBB-“. If the investment falls below this range, they usually must divest of these securities. The sudden supply in the market can make these securities decline in price, causing the yield to rise. Sometimes, securities are upgraded to investment grade. These same institutions can invest in them causing demand, making the price of these securities to rise. One study suggests that 25% of all non-investment grade securities rise to investment grade.
Here is the incentive to invest in non-investment grade or speculative grade for the individual investor or speculator. Here are the ratings used by Standard and Poor’s;
Investment Grade Ratings
AAA – Extremely strong capacity to meet financial commitments.
AA – Very strong capacity to meet financial commitments.
A – Strong capacity to meet financial commitments but can be affected by economic conditions and changes to circumstances.
BBB – Adequate capacity to meet financial commitments but is more affected by economic conditions
BBB- -- Consider the lowest Investment Grade by the investment community.
Non-Investment Grade Ratings
BB+ -- Consider the highest Non-investment Grade by the investment community.
BB – Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial, and economic conditions
B – More vulnerable to adverse business, financial, and economic conditions but currently has the capacity to meet financial commitments
CCC – Currently vulnerable and dependent on favorable business, financial, and economic conditions to meet financial commitments
CC – Currently highly vulnerable
C – A bankruptcy petition has been filed or similar action taken, but payments of financial commitments are continued
D – Payment default on financial commitments
No Rating
NR – This indicates that no rating has been requested or that there is insufficient information on which to base a rating. Standard and Poor’s does not rate a particular obligation as a matter of policy.
I look for bonds that have not been rated before looking for any other bonds because coupled with a positive income statement, they can be a good secure means of income. I only invest in “D” rated securities when I have a good hunch that the bonds will pay off with a high return in the very near future. In this economic depression, I try to stick to the highest short term non-investment grade bonds that I can.
That brings me to our next topic where we will look at short term versus longer term maturity corporate bonds.
Corporate Bonds to Study
$1,000 Bond issued by Hertz Corp 9% of 11/01/2009 Recent Price $980, Yield to Maturity 11.364% S& P Rating = NR
$1,000 Bond issued by Royal Caribbean Cruises 8% of 05/15/2010 Recent Price $890, Yield to Maturity 12.885% S& P Rating = BB
$1,000 Bond issued by Ahold Finance USA Inc 8.25% of 07/15/2010 Recent Price $1,000, Yield to Maturity 8.24% S& P Rating = BB+
$1,000 Bond issued by Ford Motor Credit Corporation 5.25% of 06/22/2009, price is $816.90, Yielding to Maturity 49.691% S& P Rating = CCC+
$1,000 Bond issued by Ford Motor Credit Corporation 5.25% of 12/21/2009, price is $693.60, Yielding to Maturity 45.517% S& P Rating = CCC+
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