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:
1. 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 corporates. Ratings agencies like Moody’s and Standard & Poor’s, two of the largest companies in the bond rating business, use the same scale for every bond sector. Each sector has a list of triple-A rated bonds, but that doesn’t mean a triple-A rated Treasury poses the same level of risk as a triple-A muni or corporate does. The same goes for each rating and category.
2. 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. Opinions can vary not only between credit agencies, but even between different analysts within the same agency. And after all, no one is perfect when it comes to predicting the future, and that’s what ratings are supposed to do.
3. 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. Nevertheless, the outcry over toxic mortgage-backed securities, many of which were rated triple-A, has cast a shadow of doubt over just how objective the rating agencies may or may not always be.
4. Things change. In all fairness to the rating agencies, our global economic and financial systems are incredibly fast-changing. Knowing that, the agencies try to keep up, and often come out with new ratings as issuers’ circumstances change, either for the worse or the better. Credit downgrades and upgrades are quite common, but with tens of thousands of bond issuers, the agencies can’t keep up with changes in every issuer’s circumstances.
5. 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.