8.3: Bond Ratings, Trading, and Quotes

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Video - Audio - YouTube (Material for this section starts on slide #37)

We will finish our Introduction to Bonds with a discussion of how bonds are rated, traded, and quoted.

Bond Ratings

When you need a loan and apply at a bank or credit union, the loan officer will run a credit report from one of the several companies that keep credit histories on virtually all citizens. The credit agencies use numeric scales to assess an individual’s credit worthiness. The credit quality of bonds is assessed very differently. Bond ratings are letter grades that designate investment quality and are assigned to a bond issue by a few designated rating agencies, the two largest being Standard & Poor’s and Moody’s. The higher the letter rating, the better the quality of the bond and the lower the risk of default of interest and principal payments.

In the wake of the 2001/2002 corporate scandals, the rating agencies were caught completely off guard. They didn’t downgrade Enron and WorldCom until they were practically in default. They were again called to task because of the 2008 mortgage-backed bond crisis that spawned the Global Financial Crisis. Yep, you guessed it! They screwed up again, but this time, they almost brought down the entire economy! Personally, Your Humble Author has always thought of the credit ratings as similar to the “idiot lights” on your car’s dashboard. By the time the [Engine Oil] goes on, it’s too late. Your engine is toast! (Friends of mine who are more car savvy tell me that the warning lights or newer cars are far more useful these days.) By the time your bond has been downgraded to junk, it is too late. You are toast!

Bond Rating Designators
Moody	S&P	Definition
Aaa	AAA	Highest grade: The “gilt-edge”
Aa	AA	High grade
A	A	Medium grade
Baa	BBB	Medium grade: The last investment grade rating
Ba	BB	Starts non-investment grade: Speculative, Distressed, “Junk”
B	B	More speculative: Moderate protection
Caa	CCC	Poor quality: In danger of default
Ca	CC	Poorest quality: Close to or de-facto default
C	C D	Moody C: In default S&P C: Not paying interest; S&P D: In default

Anything BBB or Baa or above is considered investment grade. Below BBB or Baa is considered non-investment grade, the proper and more polite term for “junk” bond status. As mentioned, in the case of Enron, the rating agencies still had them pegged at BBB as the revelations of their widespread accounting fraud were being uncovered. During the housing bubble of the mid-2000’s, the rating agencies had absurdly given their highest rating, AAA, to the associated mortgage-backed bonds backed by the “no-doc liar” mortgage loans. Many critics of the rating agencies have time and time again emphasized that the system is broken. The bond issuers pay the rating agencies for their ratings. This is a glaring conflict of interest. The rating agencies are not stupid. They are not going to “bite the hand that feeds them.” Of course, they are going to want to give their customers a high rating or else fear that their clients will look for another rating agency. When representatives of the rating agencies were called to testify before Congress after the Global Financial Crisis, how do you think they responded to these accusations? “What? How dare you suggest that we would do such a thing?” Ah, yeah, right, sure.

One last wrinkle in the ratings needs to be addressed. To further fine tune their ratings, the agencies will add a plus sign or a minus sign to the rating in the case of Standard and Poor’s or a 1, 2, or 3 in the case of Moody’s. Therefore, for bonds rated by Standard and Poor’s, AA+ is higher than AA which is higher than AA-. What’s the difference between AA+, AA, and AA-? For that matter, what’s the difference between AA, A, and BBB? Uh, I don’t know. I guess you will have to ask Standard and Poor’s.

Bond Trading

For the vast majority of bonds, bond trading is very difficult for retail investors. Many bond investors hold onto their bonds until they mature. Hence, trading volume is often thin. Many bonds trade over the counter, which means you or your broker have to find someone who owns the bonds who is willing to sell. Traditionally, one of the more reliable sources for these transactions was and still is The Bond Buyer.

However, the impediment for most retail investors is that bond traders normally trade in the $100,000 or more range. Many traders have minimum transactions of $25,000. If you can find a bond trader that will handle transactions in the $10,000 range, you can expect to be treated rudely and receive poor prices. Do you recall the famed bond trader John Meriweather and his encounter with John Gutfruend? For this reason, most of us working grunts use bond mutual funds to invest in bonds. The mutual funds have the purchasing power to buy bonds using transactions in the millions of dollars.

The exception to this grim situation for retail investors is the United States Treasury and www.TreasuryDirect.gov. As you researched way back in chapter 1, Treasury bonds, notes, and bills can be purchased directly from the Treasury and you, the lowly retail investor, will get the same prices as the big boys and girls on Wall Street. Very cool!

Bonds Quotes

Bond quotes are not quoted in dollars as stocks are. That would be too easy. The opulent and moneyed world of bonds has one last curve ball to toss at us. Bond quotes normally are quoted as a percentage of the par value, also known as the face value. For example: if you see 97.25, that means 97.25% of the par value of the bond. Recall that most bonds are denominated in $1,000 increments. That means the price of the bond would be 97.25% * $1,000 = $972.50. An easy way to determine the price of the bond is to move the decimal point one to the right. 97.25 is a bond quote for a bond selling at a discount. A bond selling at a premium would be quoted over 100. A bond selling at par would be quoted at 100.

For our purposes, we will always use $1,000 as the par value. However, do keep in mind that a few bonds are denominated in $5,000 or $10,000 increments. In the case of $10,000 denominated bonds, you would simply move the decimal point two to the right. A bond quote of 97.25 would designate a bond selling for $9,725. In the case of a bond denominated in $5,000 increments, get out your 99¢ calculator.

Unlike stock quotes, free bond quotes are not easy to come by. The Financial Industry Regulatory Authority (FINRA) is one of the few Internet websites that offer free bond quotes. You can use www.finra.org for bond quotes. Actually, it appears that they are using Morningstar for their bond quotes. If you go to Morningstar’s website, there does not seem to be any way to procure free bond quotes. Go figure. Remembering that most investors who purchase individual bonds deal in very large numbers, we can safely assume that these folks have their own private brokers who specialize in bonds. For those of you who are considering a career in the investment services industry, you will find that most of us investment professionals immerse ourselves in stocks while only a few specialize in bonds. If you find that bonds interest you, by specializing in bonds, you will not only face less competition, you will also attract the most lucrative clients. Think about it. The industry needs you!