Unlike stock investors, those who invest in bonds usually have a way to gauge how risky an investment might be. It’s the rating assigned to the bond by a credit rating agency, with triple-A being the agency’s best rating.
However, not every triple-A rating means precisely the same thing. In fact, two bonds with that same rating can present different possibilities regarding timely repayment of principal. Here’s why:
- The ratings are relative to the sector. A fundamental fact bond investors must remember is that the three major bond sectors each present different levels of risk completely apart from the ratings each bond carries. In general, from the safest to the riskiest, the bond sectors are Treasuries, municipals, and corporate. Ratings agencies use the same scale for every sector.
- Ratings are opinions. Financial ratings are opinions and, as such, are as much art as science. Ratings are based on a careful review of the numbers, and each rating agency has its own general guidelines for which numbers go with which rating; but opinions can vary not only between credit agencies, but even between different analysts within the same agency.
- The issuers pay for ratings. The rating agencies make their money from the fees they charge bond issuers. Ostensibly, the agencies are able to command the respect of the marketplace by remaining objective, despite the potential for this arrangement to affect their judgment.
- Things change. Our global economic and financial systems are incredibly fast-changing. Credit downgrades and upgrades are quite common; but with tens of thousands of bond issuers, the agencies can’t keep up real time with changes in every issuer’s circumstances.
- Bond insurance can mask problems. It’s not uncommon for issuers of municipal bonds to secure bond insurance. In that case, the bonds assume the credit rating of the bond insurance company, regardless of the state of the issuer’s finances. If times got tough for state and city governments and a large number of them were to get financially weaker, it may be beyond the wherewithal of the municipal bond insurance industry to make every bond investor whole, in spite of its high rating.
Remember that you have to look beyond any bond rating to understand just how much risk it may pose to your portfolio.
Copyright © Integrated Concepts 2013. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.