27 July 2015

Corporate And Municipal Bond Ratings By The Numbers

American Corporate and Municipal Bond Ratings

What Do Bond Ratings Mean In Practice?

On April 11, 2014, there were only three companies with AAA credit ratings in the U.S. according to S&P. Those companies were Johnson & Johnson, Exxon-Mobil, and Microsoft.
The number of companies with the top-credit rating has been dwindling for years. Back in 1980, there were more than 60 U.S. companies rated AAA by S&P. That fell to six in 2008. Since then,” General Electric, Pfizer and ADP were downgraded.
The fall in the number of AAA rated companies, however, is largely a function of the rise in the number of publicly held companies that have no long term debt at all, and hence, no bond rating, despite their exceptionally secure financial positions. As of March 31, 2014, there were 26 companies in the S&P 500 which had no long term debt at all, for a total of at least 29 publicly held companies that were ultra-secure financially at that time.

But, a company that is ultra-secure financially isn't necessary a good investment, because a company that can't find investment opportunities that produce safe returns better than the returns it is earning on its stockpiled cash and the low interest rates at which it could borrow money for long term loans, may not be trying hard enough to maximize shareholder return.  If companies like Facebook and Visa can't find investments that return the 2.5% per annum on investment over a three year time horizon that they would need to break even on new debt, or the 1.5% per annum on investment that they would need to break even on an investment of their crash reserves (at current interest rates), then we are either really and truly deep in "the Great Stagnation", or the management of those companies isn't trying very hard.

Also, an absence of long term debt like bonds, and even short term debt like commercial paper, doesn't necessarily mean that a company has no long term obligations. As noted in the link above:
Some of these companies might have other financial obligations, such as long-term leases for retail space or other equipment or short-term loans to be paid off within a year. But this analysis measures what accountants call long-term debt, or financial obligations due in more than a year, which leaves out short-term bridge loans that's not debt the company is planning to lean on for long. Most of the companies don't have short-term debt, either.
Just 800 companies (less than 5%) have investment grade bonds out of 23,000 U.S. companies with revenues over $35 million whose credit was reviewed by bond rating agencies. But, only about 1,800 companies with non-investment grade credit ratings, however, have actually issued publicly traded bonds (aka "junk bonds" aka "high yield bonds"). So, about 30% of publicly traded bonds are investment grade, less than 1% of investment grade bonds are AAA, and only about 0.2% of publicly traded bonds are AAA rated. Companies with sales of less than $35 million per year are not eligible for an investment grade bond rating.

An investment grade bond rating, in practice, roughly corresponds to a "large capitalization" stock, although in principle, bond ratings are not directly dependent upon market capitalization.

The rating system at Standard and Poors and at Fitch ranks investment grade bonds as follows (Moody's equivalent rating):

AAA (Aaa)
AA+ (Aa1)
AA (Aa2)
AA- (Aa3)
A+ (A1)
A (A2)
A- (A3)
BBB+ (Baa1)
BBB (Baa2)
BBB- (Baa3)

Moody's rating are somewhat more strict than comparable ratings by Standard and Poors (S&P) as illustrated by historic default rates for bonds of a given rating.

Historical default rates vary greatly, but in the S&P system through 2007, averaged about 0.6% for AAA, 1.5% for AA, 2.9% for A, 10.3% for BBB, 29.9% for BB, 53.7% for B, and 69.2% for any kind of C rating.  This is measured over the life of the long term bond and is not an annual default rate.

Losses When Bonds Do Default

Also, few bond defaults in senior corporate bond are a total loss.

Corporate bonds are customarily issued for a fixed term of years with each periodic payment owed by the corporation to the bond holders consisting in part of principal and in part of interest.  The more distant a default is in time from the time when the bond was sold to an investor evaluating the credit worthiness of the corporation at the time, the more principal the corporation will have paid down. Often, a third or more of the principal on a bond will have been paid before default, even in cases where there is a default.  Even when there is a default, the debt may be paid in full or in part, behind schedule, frequently in connection with a bankruptcy filing.

Holders of defaulting corporate bonds in large publicly held companies (whose rights are enforced  by a bond trustee who acts on behalf of all bond holders in a particular bond issuance to distribute timely payments and enforce their collective rights when there is a default) are not infrequently eventually paid 50% or more of their principal investment (and very nearly 100% in about one in five cases), even in a bankrupt company whose stockholders and subordinated debt holders are entirely wiped out under the bankruptcy code.

Typically (although there are, of course, exceptions to the general rule), the bankruptcy of a publicly held company results (1) in payment in full of secured creditors (i.e. creditors with collateral), of priority creditors (under the bankruptcy code), and of trade creditors, (2) in partial payment of senior bond holders and other general creditors at some percentage rate, and (3) in no payment to junior or subordinated bond holders and stockholders.  Payout percentages for senior bond holders in bankruptcy vary considerably. Generally speaking, the percentage payout from a bankrupt company is larger in a bigger company with a higher bond rating, than in a smaller company with a lower bond rating.

Bankruptcy payouts to senior bond holders in the range of 10% to 60% are not particularly unusual in bankruptcies of publicly held companies.

In companies with assets of $100 million or more, the mean payout to general unsecured creditors like senior bondholders is 41% and the median is 22% according to a 2011 study.  In contrast, the mean payout to subordinated debt, when it is present, is 15% and the median is 1%, while the mean payment to secured debt is 78% and the median is 100%.  Stockholders get nothing 80% of the time a large company files for a Chapter 11 bankruptcy (implying a median of 0% and a mean that is quite low but not quite zero).  Stock holders only get paid when the company has more assets than liabilities but an unavoidable cash flow problem that bankruptcy resolves.  Retailers are particularly unlikely to survive a bankruptcy.

In many privately held company bankruptcies, in contrast, it is rare for general creditors to receive any payout in a bankruptcy - the modal outcome is that the IRS gets everything remaining after secured creditors and other higher priority creditors are paid according to a 2007 study, which also noted that: "When a company has assets worth more than $5 million, secured creditors, those whose claims are backed by collateral, receive 94 percent of what they are owed, and unsecured creditors typically recover half.", a somewhat more optimistic data set than the 2011 study done following the financial crisis.

Municipal Bonds

Historical default rates on municipal bonds are much lower than default rates on corporate bonds with the same rating until 2010 when Moody's and Fitch abolished the separate system (S&P abolished the separate system in 2001).  More recent municipal bond issues are rated on the same scale as corporate bonds.  For example, in the old system, S&P BB rated municipal bonds have about the same default rate on average as S&P AA rated corporate bonds.  Investment grade municipal bonds as rated by any major bond rating agencies under the old system have default rates lower than AAA rated corporate bonds.

Within municipal bonds, there are two main categories, general obligation bonds, supported by the taxing power of the government, and private activity bonds, supported only by a government owned enterprise like an airport or government owned utility.  The former almost never default.  The latter default at rates comparable to investment grade publicly held companies.   Municipal bankruptcies are rare.  For example. there were just twelve Chapter 9 bankruptcies filed in the calendar year 2014, out of roughly 90,000 local government entities that could issue bonds and declare bankruptcy under Chapter 9 (many of which issue multiple classes of bonds outstanding but default because they become unable to pay only certain private activity bonds for a single activity).

State governments and territories like Puerto Rico, are not allowed to file for bankruptcy and on rare occasions due default on their debts (nine states defaulted on their debts in the 1840s, for example).

Bond Ratings and Interest Rates

Bond ratings are inversely related to interest rates.  Risker bonds bear a higher interest rate, determined in practice almost entirely by its official bond rating, which is a risk premium on top of the risk free rate of return approximated operationally by the interest rates paid on Treasury bonds issued by the United States government, top rated municipal bonds, and AAA corporate bonds.

Bond investors frequently manage the risk of a default on a bond by diversifying their bond holdings. For example, a bond fund that primarily invests in investment grade corporate bonds might very well hold a portion of every single investment grade corporate bond issuance outstanding.  Such a fund would participate in every single default of any investment grade bond, but would dilute the losses from those defaults with the gains on all of the other investment grade bonds that did not default.  A fund manager in such a fund might have purchases of new issues and upgraded bonds, and sales of downgraded bonds handled by a subordinate as a matter of routine, while devoting most of his or her attention to managing the defaulting problem children, just a few at any one time in normal times, and dozens at a time in a serious bear market.

When a bond rating falls, it typically trades at a discount necessary to give it an implicitly higher interest rate appropriate to the new rating, resulting in a partial loss to existing bond holders, while if a bond rating rises, it typically trades at an above par price that reflects the reduced risk premium.

The market capitalization of a firm, relatively to its outstanding debt, which can be monitored on a day to day basis for all outstanding bonds of companies with publicly held stock, as well as other forms of business news and analysis, provides bond rating agencies the ability to update their ratings over time for the benefit of bond traders in the secondary market.  Of course, if a bond rating falls, by that point, the initial investors in the publicly offered bonds have purchased them and can only realize and cut their losses by selling their bonds, or wait and see if the risk portended by a falling bond rating actually materializes with a default that will cause the investor an even greater financial injury.

Most of the interest rate payable on "risk free" investments is attributable to the inflation that bond traders expect over the course of the life of the bond, which is approximated operationally by the difference between the rates payable on treasury inflation protected securities (TIPS) (which have payouts tied to the consumer price index measure of inflation) and ordinary fixed rate treasury bonds issued by the United States government.  The pre-inflation adjustment rate of return on TIPS is the operational definition of a "default risk free" and "inflation risk free" investment.

The actual pre-inflation adjustment rate of return on TIPS varies with their maturity.  For example, today, 5 year TIPS had a 0.23% annualized real rate of return, while 30 years tips had a 1.05% annualized real rate of return.  In other words, interpreting the data pessimistically, the market's evaluation of the risk that the U.S. government will default on its bonds sometime between July 27, 2020 and July 27, 2045 is about 0.82% per year (or more if defaults don't produce 100% losses).  More optimistically, some of this difference is due to the minor liquidity penalty between owning long term TIPS and owning cash.

The Systemic Risk Associated With The Bond Rating System

The systemic risk concern, which came up during the financial crisis, is that three bond rating agencies which don't have money in the game and have little non-reputational stake in making bad bond rating decisions, drive the lion's share of the interest rate determination in the bond markets by all but the "smartest" money.

This systemic risk manifested in the Financial Crisis when mortgage backed securities were systemically given overrated bond ratings by the small departments of each of the three main bond rating agencies charged with rating them, who faced dubious incentives to be accurate.  This arguably corrupt situation played a critical role in the nation's largest economic downturn since the Great Depression.  Ultimately, some settlements to lawsuits brought against these agencies were paid, but the treatment of bond ratings as statements of opinion that cannot form a basis for civil liability, and the small pockets of bond rating firms relative to the harm caused by their systemic overrating of mortgage backed securities, made lawsuits largely ineffectual at resolving this problem.

The benefit of the system, however, is that more or less neutral third parties with a reputational stake in being accurate from which their influence is derived may make more informed and more accurate decisions on credit risk than any one bond investor could using only the resources available for due diligence from his stand alone bond investment in the bond issues available for him to invest in at any given time.  Bond rating is much more efficient and utilizes some of the best available methods, at the cost of group think that can create systemic risk.

Of course, bond traders are free to ignore bond rating decisions, and if they consistently are more accurate than bond rating companies when they do so, they can profit from their superior predictions.

Chinese Corporate Bond Ratings

In contrast, in China:
Around 97% of existing yuan-denominated bonds hold ratings of double-A to triple-A—the best a company can get.
That is from Fiona Law at the Wall Street Journal, cited by Christopher Balding, and ultimately Alex Frangos via Marginal Revolution.

Basically, the bond ratings of all publicly listed Chinese companies were wildly overrated.

Meanwhile, a Chinese government agency, the China Securities Finance Corp (CSF), central bank-backed refinancing institution, is now "among top 10 shareholders of many listed-firms" as Chinese regulators have stepped in to prop up a collapsing stock market. Effectively, this is turning what had until recently been a mostly theoretical communist basis of the Chinese economy into one in which state ownership of enterprise is again rapidly becoming the norm.

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