Are Credit Ratings Over-Rated?

Yes, but there are still good reasons to pay attention to them.

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Remember the now extinguished Enron and Worldcom? Both companies drew high marks from America’s top credit raters Fitch, Moody’s and S&P back in 2001—just before they declared bankruptcy.

Within a year, both companies had been completely liquidated. Shareholders were totally wiped out. So were all but a handful of bondholders, mainly those who had claims on specific assets and operations that were still functional.

That was some miss. And as these were not small companies, the damage was both far-reaching and devastating.

Before I go on any further, a word on what credit raters do: Basically, they look at everything that’s known about a company’s current financial position, all the documents filed with the SEC and elsewhere. They ask management questions. And then they assign a letter grade, based on that information as well as their read on the general economy and industry trends.

Moody’s rating system goes from Aaa (highest) to D (lowest). S&P and Fitch use a system from AAA to D (default). Moody’s uses numbers to indicate sub-levels within each grade, for example Baa3. S&P and Fitch use minus signs. So BBB- for them is equivalent to Baa3 at Moody’s.

Higher ratings are meant to designate safer companies. But the real point of demarcation is between “investment grade” and “non-investment grade” sometimes known as “junk.”

Investment grade ratings are important because they mean companies can generally issue bonds/debt at lower interest rates than can “junk” rated companies. And management will often take aggressive steps to maintain an investment grade rating if there’s danger of a cut to junk, including asset sales and occasionally dividend cuts.

Credit raters assign an “outlook” in addition to the letter grade. A “positive” outlook indicates the rater believes the rating may be raised in the next 12 months. A “negative” outlook indicates risk of a reduction. A “Creditwatch” designation may indicate an increase (positive) or decrease (negative) is imminent.

There was no negative outlook or creditwatch designation for Enron and Worldcom before the end at any of the big three raters. And that (rightly) gave them a black eye they’ve arguably never yet recovered from. Mainly, credit raters can have just a big a blind spot as equity analysts when it comes to popular companies.

By the late 1990s, many considered Enron and Worldcom the inevitable “disruptors” of industries that had known little real change for decades, electric utilities and telecoms respectively. And only a handful of investors—notably short seller Jim Chanos—were able to pierce the veil both operated under.

I freely admit that I was not one of them. And as a result, I let what had been substantial profits in both stocks essentially evaporate. What ultimately convinced me to bail out was (belatedly) recognizing there was something going on I didn’t understand.

In the end, investment advisory rater Hulbert Financial Digest credited me as one of a tiny handful of analysts who sold “before the roof fell in.” You can still read the article on Forbes from December 7, 2001. And quoting Mr. Hulbert, we six investment newsletter writers “covered (our)selves with glory” when “11 of the 13 Wall Street analysts following Enron rated it buy.”

I can tell you it sure didn’t feel that way to me. But I did learn a very valuable lesson as an investor and as advisor.

It really boils down to what former president Ronald Reagan said about negotiating with the former Soviet Union back in the 1980s: “Trust but verify.”

Credit ratings remained a big part of my analysis for reasons I’ll reveal shortly. But never again would I simply assume a high credit rating automatically ensures a business is strong and financially healthy. Equally, a “junk” rating doesn’t always mean insurmountable risk.

I still watch credit ratings closely. And in fact, I make a point of attending analyst conferences sponsored by credit raters—in person as well as virtually—especially when they concern industries I’m focused on like utilities and energy.

The credit raters generally do a great job of collecting data. And I’ve picked up some great insights when credit raters have sponsored breakfast presentations at Edison Electric Institute Financial conferences.

But that said, S&P analysts also forecast a decade-long depression for US electric utilities following the collapse of Enron. Anyone who really took that to heart missed out on an historic recovery. And there are frequent other examples of raters missing the boat since, like the mortgage-backed loans that triggered the financial crisis of 2007-09.

Bottom line: Credit raters are worth listening to. But they’re just as prone to getting it wrong as any other market analysts and participants. And using credit ratings effectively in your investment strategy means keeping those limitations in mind at all times.

So what are credit ratings good for now?

Being rated investment grade is critical for companies’ cost of capital at a time when the global economy is showing signs of slowing. And the US Federal Reserve is not inclined to throw it lifeline, so long as it’s worried about the inflation impact of tariffs.

If the economy does continue slowing, investors are going to demand a higher rate of return—interest rate—to buy bonds of companies not rated investment grade. Even if there’s not a recession, that means higher interest expense for many companies. Some will find themselves cut off from capital markets entirely.

Now more than ever, it’s important to ensure the companies you own can weather that kind of environment. And having investment grade ratings—while again not a foolproof measure of lower risk—is nonetheless likely to be increasingly critical to accessing capital markets, including for refinancing debt.

I still believe the Fed will deliver on its guidance for two-quarter point cuts in the Fed Funds rate by the end of the year. In fact, if inflation is well behaved it may do more. But if the economy is weakening, lower rates will only benefit investment grade companies.

There is one group of junk rated companies that will also do well. Those are businesses on the come that are demonstrably getting stronger. And as they do, they’ll become eligible for upgrades to investment grade—and be able to issue debt at lower rates. Two junk-rated US utility candidates for such boosts: Hawaiian Electric (NYSE: HE) and PG&E (NYSE: PCG).