Chris Duncan asked: Credit Rating Agencies are suppose to provide an unbiased, objective rating on various instruments that an investor can partake in. Over the years they have done a pretty good job. Unfortunately, much of the current turmoil is due to agencies giving high ratings on debt instruments that were really too complex to understand and weighted ratings towards the high end on an assumption of future growth.
Wow, I almost sound like one of them. That is really scary. In English then. Credit agencies were giving very high marks for the bundled debt that banks were selling. Packages were put together with large amounts of good loans and some riskier loans. The problem was the assumption was that even if the riskier loans went bad, the asset (usually a house) would be able to be sold for more than it was originally purchased for. And of course that lasted for quite a few years. But then some of the loans (I almost wrote loons) started going bad. And then a lot of them. Finally, home prices started to drop dramatically and it was a downward spiral from there. So why is this important, well you need to take ratings with a grain of salt and sometimes you might want to do some of your own digging.
My focus is going on ratings for municipal offerings. Moody’s and S&P (Standard & Poors) are the most common. Some municipalities will also use Fitch. It makes you wonder if the municipality doesn’t shop around for the one that will give you the highest. But thinking like that makes the black hats come out and I try to avoid that. Moody’s highest rating is triple A (A a a). Yes, it is shown as a capital “A” followed by two lower-case “a”s. Maybe because there is already a Triple A insurance agency and Alcoholics Anonymous. If the investment you are buying is in the A range, it is considered to be a “low credit risk” (probably won’t default). There are three tiers. A a a — highest quality with “smallest degree of risk” Aa1, Aa2, Aa3 — high quality with “very low credit risk” A1, A2, A3 — “upper-medium grade” with “low credit risk”. Hmm seems a little sketchy
S&P has a similar rating scale but their top 3 tiers are A A A, AA, & A. They use a + or – to denote a rating that is slightly above or below the main tier such as AA+ or AA-. A bond with a rating in the B range is becoming on the more risky side. Moody’s has a Baa2, Baa3, and Baa3 and S&P has a BBB+, BBB, BBB- that are considered adequate but it wouldn’t take much for those bonds to start going south. Below that and you would be in the High Yield or Junk bond status. Rarely do municipal bonds get in that range. Also they rarely default.
When it comes to municipal bonds there are two basic types a General Obligation (GO) and a Revenue Bond. GO bonds are deemed the safest for the investor as they are tied to tax revenue and the general ability of the entity to raise taxes if necessary to pay the debt back. Of course this may not seem like such a good deal for the citizens if their taxes are raised. Some states have issued laws (such as California) that make it more difficult to raise taxes without public support. Generally, GO bonds from a healthy municipality with good tax revenues and future growth prospects would receive the top rating.
A Revenue bond on the other hand is a bond issued to build a bridge, hospital, stadium, etc. that is paid back with the revenue (fees, taxes, tools) it generates. So its rating is based on the outlook for the project and likely future success. A bridge in Death Valley might not have as good as a prospect over the San Francisco Bay. Usually, the municipality is fairly certain of success and has done their homework. Ratings are typically in the third to second tier. But again, check out the community and see what is going on. Search Engines can be a wonderfully powerful tool in that regard.
As always I hope this has been helpful. Technically, I’m a CD guy, but this seemed like a useful and helpful topic given where yields are currently.
Tanya
