A Bond Rating's Worth - Buyer Beware

by: Carl Dincesen

What's a bond rating worth? The better question is, how much do you rely on them? The answer for retail municipal bond investors is, completely.The point of ratings is to help investors obtain compensation that is at least commensurate with credit risk taken. There aren't any good or bad bond ratings. Just those that are misplaced on the rating scale.

To be valuable credit ratings should quantify how much credit protection stands between bond owners and default over a specified period and for how long that rating is reliable.

Probability of default is the only valid measure of investor protection or degree of credit risk. It is implicit in "official" bond ratings in use today. They are not explicit because to do so would not be in the best interest of the sell side i.e., raters; issuers, their customers; and, investment bankers.

A one percent chance of default over the next 10 years also means a 99 percent chance of being paid on time. Most agree that would to be a comfortable amount of credit protection.

We assume a recession occurs during that time. We use the unemployment rate to mark the boundary of economic adversity. The depression scenario is too infrequent for use as a statistical benchmark.

The number of rating categories has grown from John Moody's original six to four times that number. By rating agency definition, their ability to quantify risk has not changed in the last 100 years, but their ability to parse it further has. We found that six gradations are all that are necessary to quantify credit risk. We stop at a 25% default rate. Beyond the line between investing and gambling blurs.

On the Benchmark Rating Scale, a one percent probability is the definition of a rating category 3 rating on a 1 through 6-risk rating scale. The rating is good for five years versus one year for government bonds rated - 6 the highest level of risk or least amount of protection that we label "Less than thin."

This is what a credit rating should bring to the investor. That would leave the motivation and point of view of professionals doing the ratings as the only variable. Rating Table:

(Click chart to enlarge)
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Disclosure: I am long MCO.