Credit ratings help investors determine risk

Not all bonds are created equal.  More importantly, not all bonds are considered low risk.  Terms such as non-investment grade, high yield and junk bonds are often associated with higher risk bonds.

Government of Canada bond yields are the benchmark for bonds in Canada.  The yields are often quoted in the newspaper for the GOC 2, 5, 10 and 30 year maturity bonds.  Yields on GOC bonds are low because of the very high credit quality.  The Government of Canada has never defaulted on any of its debt obligations.  It is these bonds which other bonds such as Provincial issued and Corporate issued are compared.  Many people may be surprised to learn that the only province to ever default on a bond is Alberta.  This occurred in 1936.  However, bondholders did not lose their capital as the federal government provided the capital to pay out the bond holders on behalf of the province.

Rating agencies were created to help clients measure relative safety of different companies issuing bonds.  Three major rating agencies are Standard & Poors (S&P), Moodys and Dominion Bond Rating Services (DBRS).  These companies provide credit ratings on bonds (and certain other types of investments).

As an example, DBRS provides independent credit analysis on government debt, short-term corporate debt, preferred shares and long term corporate debt. DBRS assigns a letter grade that indicates the credit risk of the bond issue.

From DBRS, the following are the letter grades, credit rating and explanations:

  • AAA Highest Credit Quality: Highest credit protection, excellent financial health, very profitable future outlook, strong and stable industry and earnings (it is rare to achieve a AAA rating).
  • AA Superior Credit Quality: Very high credit protection, profitable future outlook, good financial health, strong and stable industry and earnings. Marginally below AAA.
  • A Satisfactory Credit Quality:  Good credit protection, medium to large company, fair to good financial health. Slightly cyclical.
  • BBB Adequate Credit Quality:  Adequate protection, fair future prospects, adequate financial health, more economically susceptible.
  • BB Speculative Credit Quality:  Uncertain protection, quite susceptible to changes in economic conditions, smaller size, less liquid.
  • B Highly Speculative Quality:  Highly uncertain protection, volatile earnings and highly susceptible to economic fluctuations.
  • CCC Very Highly Speculative:  Little or inadequate coverage, in danger of           Quality         default if situation not remedied.
  • CC Extremely Speculative:  Even higher danger of default than CCC rated quality bonds if situation not remedied.
  • C In Danger of Default:  In immediate danger of default. Lowest possible rating without actually being in default.
  • D Default:  Currently in default of principal and/or interest.

The above is one example of a company’s rating system.  The rating agencies each have a slightly different system.  Most use a three tiered nomenclature within each letter grade such as “low”, “mid”, or “high” to differentiate even further.   For example, an A High (AH) would indicate the highest rating within the single A grade, which would be one notch below a AA Low (AAL).

Rating changes for a corporation can have a significant impact.  Potential downgrades result in future financing efforts becoming more costly and difficult.  Pension plans, and certain managers may have guidelines as to the quality of fixed income investments they are permitted to hold.  The BBB rating and above is considered “investment grade.”  A downgrade beneath this level may result in some investors forced to sell these bonds.

Bonds with lower credit ratings are considered riskier investments and have a higher probability of default.

However, as an investor considering a lower credit quality bond you should be expecting a higher potential rate of return.  Investors must always balance the risk of default prior to maturity.

We encourage our clients to invest in fixed income that is considered investment grade (BBB) or better.   Here’s our three rules for minimizing risk when investing in fixed-income securities:

  • Focus on investment grade fixed income
  • Avoid structured products that can be costly and thinly traded
  • Diversify by purchasing different types, issuers and maturity dates.