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Playing the Ratings Game

Care to take a guess at Lehman Brothers’ credit rating right before its bankruptcy?

I’ll give you some help.

Investment-grade ratings range from AAA down to BBB- (on the Standard & Poor’s ratings scale). Anything below investment grade (BB+ and below) is considered high yield, which is also known as speculative grade, sub-investment grade, or “junk.”

The higher the credit rating, the higher the perceived credit worthiness. In other words, high-rated companies can probably pay you back.

Thus, you’d assume Lehman Brothers had a solidly junky rating – perhaps CCC – reflecting the high risk of default during the credit crisis… right?

Actually, Lehman had an “A” rating right before it went bust!

The major ratings agencies – Standard & Poor’s, Moody’s Investors Services, and Fitch Ratings – took a lot of flak for this egregious misjudgment.

To be sure, credit ratings still provide valuable information. In fact, looking up the credit rating and reading the commentary from the ratings agencies is a great place to begin when evaluating a stock.

You can access Standard & Poor’s ratings for free by registering on their site.

Just keep in mind that the ratings agencies may have missed some material risks.

Therefore, we should really take notice when a company has a high-yield rating. Yet, most equity investors are unaware of the credit ratings of their holdings.

For example, the following table shows three real estate investment trusts (REITs) that are in the S&P 500.

Risky REITs

Equinix Inc. (EQIX), Crown Castle International Corp. (CCI), and SL Green Realty Corp. (SLG) specialize in data centers, wireless communications towers, and commercial properties, respectively.

I guarantee that the vast majority of retail investors in these stocks have no idea that the S&P’s long-term issuer rating of these REITs is sub-investment grade.

It’s easy to see why these REITs have relatively low ratings, too. Their net debt (debt minus cash) to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios are all at least 4.0 times, which is high.

The average net debt/EBITDA in the S&P 500, excluding financials, is 1.36 times.

At a time when many high-yield bonds are coming under significant pressure, investors need to be vigilant.

I’m not saying that these companies will default on their debt. However, I do think these REITs should have much higher yields to compensate investors for the additional risk, which is being ignored.

The cost of debt capital will likely rise for most high-yield issuers during the next few years. This will be a painful process for unsuspecting equity investors in highly leveraged companies.

“Rate” Your Portfolio

Most stock watchers fail to appreciate the inextricable linkage between the credit and equity markets. Keep in mind, very few companies have rock solid balance sheets like Johnson & Johnson (JNJ), which is AAA rated.

Sadly, many people’s idea of “research” involves pulling up a stock chart and (improperly) drawing some trend lines. If that’s the extent of your analysis, then you shouldn’t be investing in individual stocks. Stick with exchange-traded funds (ETFs).

If you insist on individual stocks, at least do some credit analysis on your portfolio. You’ll thank me when defaults spike, sending shockwaves through the credit – and equity – markets.

Safe (and high-yield) investing,

Alan Gula, CFA