Credit ratings are poorly understood outside of finance. In fact, bond markets generally are poorly understood. While stock valuations are headline news, changes to the bond market rarely get past Bloomberg, even failing to get much discussion on CNBC let alone the evening news.
This is folly, and it’s also an opportunity. The lack of knowledge of bonds and bond markets has made it a more inefficient market, which results in asset manager outperformance being more common than in equities. While beating the index is hard when your index is the S&P 500, many fund managers find the various bond indexes quite easy to beat. The implication for financial workers, obviously, is that the bond market is a place to both generate alpha and earn a higher income, despite the popularity of the stock market among retail investors and up-and-coming financial analysts and finance students.
A prime place to start to understand bonds is the bond ratings that are given by the various credit agencies, with Moody’s, Fitch, and S&P being the most important agencies for investors to be very familiar with. These companies publish some free reports and overviews of credit markets, which aspiring financial professionals should read with some consistency. One should also be familiar of the various credit ratings that are given.
Another valuable point to be familiar with is the relationship between credit ratings and financial markets. There is an obvious relationship between a single bond’s rating and its price; higher ratings get higher prices and vice versa. But aggregate ratings will also impact a sector’s aggregate price. For instance, when oil fell in 2014 and energy bonds were downgraded left and right, the aggregate price of energy bonds fell as well.
This had some effect on the overall bond market, but the relationship between it and the ratings of energy bonds is much more complicated and less proportional than the in-sector changes. When energy bonds fell, for instance, bonds in some other companies that benefit from weaker energy prices did not fall in price—and some either rose or should have risen (in 2015 and thereafter defaults began falling aggressively outside of energy, partly because of higher margins resulting in the lower energy prices).
Then there is the relationship between the bond and the stock market. There are some generalizations here that often (but not always) hold true. For instance, junk and stock markets tend to be closely correlated, and U.S. Treasury and equity markets are inversely correlated. But the relationship between equity prices and credit ratings is much more complicated. Falling ratings in 2014 did not affect the equity market (excluding energy) at all, and improved credit ratings in 2018 failed to help the equity market. But a good analyst can see when confounding factors cause some loose correlations to break down—and an even better analyst can find a way to profit off these irregularities.
In the end, understanding both credit risks and the meaning of credit ratings can help analysts not only win in the more lucrative credit market but also to understand the equity market and the context in which it moves. That will make a much more well rounded and, ultimately, better performing financier.