MAKE JUDICIOUS USE OF BOND RATING REPORTS

Everyone knows bond ratings can be inaccurate. Some well-known examples are Enron Corp. of Houston, which collapsed just four days after it was rated triple-B; New York-based Lehman Brothers Holdings Inc., which went into bankruptcy protection just five days after it received a single-A rating; the years when subprime mortgages were transformed into triple-A bonds through magical modeling; and the triple-A-rated bond insurers, which were downgraded in 2007 and 2008.

Not surprisingly, investors often question the reliance that we, as portfolio managers, place on ratings.

We think that they should be read, but as just another data point.

The ratings agencies do provide useful information as a result of their unparalleled access to upper management, huge staffs of industry specialists and long histories with the issuers.

When a company wants to issue a bond, someone at each rating agency has a record of everything the company has said, going back many years, what the competitors look like and so forth.

Rating agencies help us determine the questions to ask for an industry and for a bond issuer, as well as the benchmarks to track.

However, ratings can’t be blindly accepted as fair and accurate. It is smarter to assume that the ratings are wrong, and then perform your own credit analysis to confirm or deny their accuracy. This review process is one that money managers need to carry out on a regular basis.

There is no getting around the fact that rating agencies are paid by bond issuers, which presents a possible conflict of influence.

Although this may not be the ideal arrangement, it shouldn’t be a deal-killer. It may skew the ratings to the upside, but there is much more to a rating report than the rating itself.

It is the text of the report that money managers should care about.

Investment managers should perform their own independent financial analysis as well. They should obtain quarterly and annual financial statements, either via Bloomberg or another news service, by request to the bond issuer or on the issuer’s website.

They should also compute credit metrics such as operating margins, interest coverage, debt leverage, cash flow to debt, days of cash on hand, cash to debt, and debt to earnings before interest, tax, depreciation and amortization. It is important to monitor trends in these metrics.

This self-conducted financial analysis can help reveal weaknesses in ratings reports.

Additionally, there are other indications that investment managers should look for. 

For example, the market value of a bond is a leading indicator of how ratings will change in the future. Therefore, it is important to keep note of where bonds are trading in the real world.

For this reason, bonds that are marked to market daily, as most are, are preferable. Money managers should produce or receive a daily report, bond by bond, of changes in each bond’s market value.

Suppose a bond declines to 101, from 103. That is sufficient reason to run a check on the credit quality of the security.

Is there some news on the credit? Is the issuer located on the Florida coastline where a hurricane is forecasted to strike? Did the issuer’s chief executive resign unexpectedly?

Ratings are blunt measurements of overall credit quality.

They measure the capacity and likelihood of timely repayment of principal and interest. They ignore some factors that investors care about, including collateral and security.

If a bond is secured by a valuable asset that can be easily seized, it makes little or no difference to the rating, but a large difference to investors. Ratings often make no distinction between obligors that have stringent financial covenants and obligors that have none.

You shouldn’t expect ratings to be perfect; however, we do think that the following three changes would go a long way to improving them:

* To begin with, rating agencies use rating scales that includes 20 shades of credit quality, from AAA to CCC, including all the fine gradations of pluses and minuses. The scale is flawed because credit analysis is simply not that precise. The agencies should reduce their scale, from 20 to no more than 10 rating grades.

* Ratings should change more frequently for a specific credit. The agencies are loath to change ratings, thinking that investors want them to “rate through the credit cycle.” Actually what investors want is for ratings to be as accurate as possible at all times.

* The agencies should not assign the same rating to all a company’s debt, especially debt with differing maturities. Now, a company’s one-year bonds have the same credit rating as its 20-year bonds. This is inaccurate because longer bonds carry more credit risk, because certainty fades as the time horizon lengthens. They should carry lower ratings.

Josh Gonze, is managing director and co-portfolio manager for municipal bond funds at Thornburg Investment Management Inc. in Santa Fe, N.M.

Related Topics: Investment Strategies