Rating Changes and Your Investments

A variety of events or occurrences that can affect the ability of an issuer to repay the principal and interest on its debt may cause a bond’s rating to change. These can include changes in the economy or business climate, demographic changes within a jurisdiction, an acquisition or management changes, an increase or decrease in tax rates or projected revenues, or regulatory changes. For investors, here are some things to consider when a bond’s rating is raised or lowered:

Rating agencies rate bonds. They are private companies that evaluate a bond issuer’s financial health and assess its ability to repay its obligations in a timely manner. A rating is an evaluation of the likelihood that an issuer will repay the principal and interest of a particular bond on time and in full. In the United States, the major rating agencies are Moody’s Investors Service, Standard and Poor’s, and Fitch Ratings.

Investors’ perception is key. In many instances, the price of your bonds will go down when their credit ratings are lowered. This is not always the case, however, because prices are determined by investors in the marketplace and investors consider many factors other than ratings in making investment decisions. For that reason, bond prices can also change prior to a rating action as investors make their own assessments of the changing risks. Alternatively, of course, when a credit rating is raised, the price of your bond could go up.

Bond insurance, widely available on municipal securities, and also found on some other types of bonds, can provide an additional measure of protection against credit risks. A bond insurer guarantees timely payment of principal and interest in the event of a default. As a result, insured bonds usually carry the highest credit rating, or Triple-A, and are thus not as affected by changes in the issuers’ credit rating.

Bond insurance is usually purchased by bond issuers at the time bonds are initially sold. Bond insurance is not available for purchase by individual investors.

When a bond’s rating is downgraded, investors should assess whether the problem is temporary or longer term. You should also determine your risk tolerance and review your investment strategy. Your investment advisor can help you determine if the bonds still fit your investment objectives.

Ratings agencies make bond ratings and warnings of potential rating changes known by issuing press releases and posting the information on their Web sites. They also respond to telephone inquiries. The chart above describes common bond ratings.

In early April 2010, Fitch Ratings overhauled the way it assigns grades to the credit quality of state and local governments, recalibrating ratings on 40 states, the District of Columbia, the Virgin Islands and Puerto Rico. The move affects some 38,000 municipal bond issues. The rating agency’s wholesale recalibration is in part recognition that municipalities were being held to a higher standard than corporate and sovereign debt. Municipalities historically exhibit stronger repayment patterns than corporate borrowers in the same credit rating bracket. The municipal rating recalibrations are a way to align municipal bonds with debt from other sectors.

Bond issuers are also required to publicly disclose information that could potentially affect their securities. If such an event occurs, it will usually be reported in the financial or general press. Your investment advisor can also be a source of information.