The following is the Fixed Income Strategy article from the 2010-Q1 issue of Portfolio Insights.

Abraham Lincoln once asked an audience, “How many legs does a dog have if you call the tail a leg?”  After many in the audience answered “five”, he said, “The answer is four.  Calling a tail a leg doesn’t make it a leg.”  This wisdom can be applied to the ratings of many bonds today. 

One of the primary drivers of the credit bubble was the ineptitude of the ratings agencies to accurately label the risk associated to certain mortgage-backed securities (MBS) and their derivatives.  The agencies (Moody’s, S&P, and Fitch) all used flawed models that assigned ratings values to structured bonds based on mortgage collateral.

In the chart above, you can see the estimated three-year default rate at the time that the ratings were assigned and what the actual default rate has proven to be. For example, a AA- rated bond had an estimated average default rate of 0.05 percent over a three-year period, while  its actual average default rate has been 12.03 percent.  These forecasts are not just in a different ballpark – it is a completely different sport!

Investors have historically put too much credence in the rating of a bond.  Because these securities carried “Investment Grade” rating, too many people assumed they were safe and thought they could enjoy a free lunch of higher yields with the same credit risk as other Investment Grade securities. Only when it was too late did investors understand the risks that they had taken. 

How does this apply today? 

With rates very low across all fixed income sectors, investors are reaching out for yield any way they can. Once again, we are hearing people say “it’s investment grade, it should be safe.”  But history has proven that ratings are not the bible.

Certain MBS that were Investment Grade just two years ago are now defaulting at over a 50 percent rate! Countless corporate bonds have gone from A rating (middle investment grade) to default in the blink of an eye (most recently AIG, Lehman, Bear Stearns, GM, Chrysler – just to name few).

The point is that ratings can be one indicator to use while valuing a bond, but it should not be the sole indicator due to its flawed history.  Credit risk is difficult to predict as it highly event driven.  The best protection is diversification.

Investors must now keep this in mind particularly in the municipal bond market.  The rating agencies have changed their models for rating municipal debt.  In the past, they used different models to rate corporate debt and municipal debt.  Now, the metrics and models used will be much closer.  This is supposed to make evaluating credit between these asset classes easier. 

However, it will result in many muni bonds receiving higher ratings than they would have gotten in the past.  So, at a time when municipal budgets are paper thin and credit risk is increasing in the muni bond market, issuers will receive better ratings.  It is counterintuitive measures like this that cause assets to be mispriced in the market and investors may be taking on much more risk than they think.

Ryan Craft, Senior Analyst