Bond Ratings

December 2, 2013

Investment Newsletter for the end of November, 2013

This month I am going to continue discussing bonds.  First, however, the happy score card.  The Dow closed the month at 16,086, up 540 points for the month (a 3.47% increase).  The S&P 500 closed at 1,806, up 49 points (a 2.79% increase).  The Russell 2000 increased to 1,143, up 43 points (up 3.91%).  Everybody made a lot of money.

Bonds are issued either by corporations or by government entities.  The issuer wants to borrow money.  If I buy an original issue bond, I am loaning my money to the issuer.  I want to be paid interest and I want my money to be safe.  I can sell my bond on the market at whatever price exists at that time.  If I buy a bond on the market rather than from the issuer, I am not loaning money to the issuer.  I would be assuming someone else’s loan.  The issuer still owes me money, I still want to be paid interest, and I still want my money to be safe.

I have limited ability to evaluate the issuer’s finances.  There may be different levels of collateral on each bond issue.  There may be complicated financial setups and intercompany arrangements.  There may be a history of paying bond holders no matter what or stiffing them at the first excuse.  The evaluation is highly specific to the corporation or government entity.  To evaluate this issuer, a specialist is needed.

Luckily, when there is a need, someone is willing to sell a solution.  There are five private companies in the United States that rate bonds for financial security.  Only three are big enough to matter.  The three are Moody’s, Standard and Poors, and Fitch.

They issue their ratings with a letter grade.  The ratings range from AAA (called a triple A rating) to a low of D.  D is for issuers already in default.  The exact letter line up varies among the rating agencies.  There are many in between steps.  The above average grades are A (upper medium), AA (high quality), and AAA (best quality).  The B grades are average creditworthiness.

Risk is rewarded by higher profit.  Low risk is punished by lower profit.  Lower bond ratings mean higher risk, which in turn means higher a higher interest rate.  If you buy very low rated bonds, you have bought junk bonds.  You will be rewarded with very sweet interest rates, unless the issuer defaults and you lose everything.

Some issuers, like government entities, must continually issue new bonds.  There is always a new airport expansion, library construction, need for operating capital, etc.  These issuers care deeply about the credit rating.  A drop in credit rating means they have to pay more interest on future issues of bonds.  Because the borrowings are often large, the interest pay outs can often increase by many millions of dollars per year.

The bigger problem for bond holders is what happens when they already hold a bond and then it is down rated.  Since interest rates have to go up, the value of your bond must go down.  The issuer is only changing the payout for future issues.  You are stuck with the same payout.  The bond goes down in price so that the payout divided by the price (i.e. the yield) equals the market rate.


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