Do Credit Ratings Merit Your Attention?

In every issue of Income Securities Investor we report the latest credit rating changes by Moody’s and Standard & Poor’s. Also, we provide benchmark yields and spreads geared to ratings. When it comes to our bond and preferred recommendations, we show the agencies’ ratings, yet the rationales for our investment opinions are based on our own, detailed securities analysis. What, then, is the relevance of the ratings and why do we allocate so much space to them? Alternatively, investors might wonder why analysts can’t simply rely on the agencies’ ratings, given that they, too, perform rigorous analysis.

A key point in addressing these questions is that rating agencies and we securities analysts have different functions. Moody’s and S&P specifically state that their ratings are not investment recommendations.Ratings primarily address default risk and in aggregate do a pretty good job of it. But default risk is just one of several factors that securities analysts take into account in making a bond or preferred a BUY, SELL, or HOLD

If every issue of a given rating traded at the same yield, you might simply find a risk level you’re comfortable with and buy an industry-diversified basket of issues with that rating. In reality, though, bonds or preferreds of any given rating vary widely in yield. For example, on March 31 the yields on medium-BBB issues in the ICE BofAML Fixed Rate Preferred Securities Index ranged from a high of 6.16% to a low of 2.53%.

How can two issues that the agencies rate equivalently be regarded so differently by the market? It’s due to those factors other than default risk that influence price. In the case of preferreds, an analytical model developed at Lehmann Livian Fridson Advisors LLC finds that most of the variance in yields that’s not explained by the rating is explained by the coupon rate, the sector (either bank or non-bank), and a 12-month measure of price momentum. Another factor that’s not addressed by ratings, but which affects an issue’s price, is susceptibility to early redemption. For convertibles, the price of the related stock makes a big difference.

In summary, ratings are genuinely useful inputs to income-oriented investment decisions, but it takes much more to determine whether a security offers good value.