Using bond ratings reports judiciously

Everyone knows that bond ratings can be inaccurate. Some well-known examples are the triple-B rating earned by Enron Corp. of Houston just four days before its collapse and the single-A rating awarded to New York-based Lehman Brothers Holdings Inc. just five days before it sought bankruptcy protection.

And let’s not forget all those years when subprime mortgages were transformed into triple-A bonds through magical modeling, or 2007 and 2008, when the triple-A-rated bond insurers were downgraded.

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

We think that ratings 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 ratings agency has a record of everything the company has said, going back many years, as well as what the competitors look like and so forth.

Ratings agencies help analysts determine the questions to ask a bond issuer and which 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.

There is no getting around the fact that ratings agencies are paid by bond issuers, a potential conflict of interest.

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 ratings report than the ratings themselves.

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 Bloom-berg or another news service, by request to the bond issuer or from 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.

There are also other indicators that investment managers should look for.

For example, the market value of a bond is a leading indicator of how ratings will change. Therefore, it is important to keep note of bond prices.

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.

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

If a bond is secured by a valuable asset that can be seized easily, 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.

Advisers shouldn’t expect ratings to be perfect; however, the following three changes go a long way to improve them:

• Fix the ratings scales. Agencies use scales that cover 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 precise. The agencies should reduce their scale from 20 to no more than 10 ratings grades.

• Update ratings more frequently. The agencies think that investors want them to “rate through the credit cycle,” which makes them loath to change ratings. Ratings should change more frequently for a specific credit.

• Don’t assign the same rating to all a company’s debt. A company’s one-year bonds carry the same credit rating as its 20-year bonds. That makes little sense, because longer bonds inherently bear greater credit risk. 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.

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