Despite missed calls and ethical questions, ratings firms will remain influential. That's not all bad. By Jeffrey R. Kosnett, Senior Editor September 2, 2009 Bond ratings and the people who issue them are easy targets. From the failures of Enron to WorldCom to the blowup of subprime mortgage-backed securities and the weekend death of Lehman Brothers, ratings firms said little until after the investors and the public got crushed. Congress has held hearings for ages and regulators and scholars have forever alleged that Moody's, Standard & Poor's and their few competitors like to swallow their whistles, influenced by the fees they charge the very bond issuers the public expects them to judge candidly and impartially. The Obama administration's proposal to reinvent financial regulation includes a provision to have the Securities and Exchange Commission supervise credit-rating firms and another that would require ratings releases to convey much more information, including "qualitative" judgments about the expected losses in the event of default. That reads like a prelude to coming up with a whole new system to express the safety of a bond or an annuity or an insurance policy. Yet even this harsh document preserves the current ratings providers and the letter-grade system, which John Moody started exactly 100 years old. I expect the ratings to roll on for a long time. I've asked countless bond-fund managers and investment advisers who question the quality of ratings if they know of a better business model or regulatory process that would remove suspicion and encourage ratings firms to deliver meaningful, actionable advance warnings. They struggle to think of any. "Are you kidding me?" says Bill Walsh, partner of Hennion & Walsh, a New Jersey municipal bond firm. "Let the government do it? No politics in that, huh?" Can't argue that one. Imagine the mess if a company needing to float bonds had to pay a fee to the government to get a good enough rating? Advertisement The sensible point for discussion here isn't whether the SEC should rule whether a bond is properly rated or gain the power to remark on a specific bond issue in a way similar to a mandatory automobile recall. It's how you should use ratings firms' grades and their other information. First, read the reports. Bond ratings firms can tell you much more than just a letter grade about a company or a tax-free issuer. Patrick Sporl, a corporate bond fund manager for American Beacon, observes that ratings agency staff is not bound by Regulation FD, the rule that blocks stock analysts' access to selective non-public information about a company. Ratings agency employees can get whatever information they need or want, and so they should have an advantage over other observers. So if you're thinking of buying a corporate or municipal bond or any risky security, you might figure Moody's or S&P or Fitch Ratings knows plenty. You can't justify paying the very high subscription fees to get full Moody's or S&P service, but much of what they know and say about an individual bond issuer seems to get around the Internet. There's nothing to stop a financial adviser from sharing this with you, either. Fitch, the third-largest firm, puts a lot of its news and commentary on its site (www.fitchratings.com for anyone to see. Second, keep downgrades in perspective. Whenever a ratings agency issues a downgrade, even if it's only taking the city or insurance company or whatever from AAA to AA+ (Aa1 in Moody's scale), it tends to get headlines, especially if it's a state or a well-known company like General Electric or MassMutual. Normally this cuts into the market value of a security or other investment because the lesser the rating, the higher the interest rate these companies will have to pay when they next borrow money. Advertisement However, a one-step downgrade is rarely a prelude to serious solvency problems. If you're going to buy a bond for the income and hold it, what matters is that you get your interest on time and the principal back. In that case, it's meaningless if the bond's rating goes from AA-minus to A-plus. (The same is true if you own a cash-value life insurance policy. It's silly to dump it because the company is AA instead of AAA). Governors and state treasurers are arguing anyway that all general obligation state debt should be on a par with the U.S. Treasury, which is either AAA or above the ratings process, because it's nonsensical that a state government's power to tax and its unconditional backing can possibly be a worse credit risk than even the soundest private company. Although states are hurting in 2009, I can see this point. GOs are safe. Corporate bonds rated A or higher should be safe, but this is where the system failed. All those busted mortgage securities carried ratings as high as AAA when they collapsed and their value fell by 75% or more. Third, look for ratings and yield inconsistencies. In September you could go to the Charles Schwab bond site and see a representative ten-year A-rated muni yielding 5.2% and a ten-year AAA at 4.6%. Then go to the actual listings and you find oddities: some ten-year A-rated bonds paying as little as 3.9%, while in the AAA ranks (supported by tax revenues, not bond insurance) you could still find more than 4.6%. Clearly, ratings aren't driving everything here. Bond-fund managers say they rely more on their own research to evaluate a bond's price and yield. This gives a diligent bond buyer-or fund manager-more opportunities to find quality higher-paying securities at a discount.