A New Proposal For Rating Bonds

Okay, so is a bond with a Ba1 rating from Moody’s better or worse than one rated Baa3? And what’s the difference between a B+ and an A- at S&P?

At Moody’s, evidently a rating with a “3” in it outranks one with a “1” – provided it has more lower-case “As” to compensate. So Baa3 is better than a Ba1.

And at S&P, it certainly isn’t like school where a B+ ranks just below an A-. There are six levels in between the two (BB-, BB, BB+, BBB-, BBB, and BBB+).

I don’t know much about the bond market, but can’t we invent something better than a system that resembles Roman numerals? It seems rather silly. It makes me wonder if bond traders think in terms of a bond having a yield of around VIII% if its coupon is IX and is trading at CXI. Is that worth investing a few Ms?

But I do have a serious point. I think there’s a better way for portfolio managers to evaluate the risk of various corporate, municipal, and sovereign bonds than relying on a group of rating agencies.

Market-based ratings

David Merkel says we should eliminate ratings agencies entirely. All I’d like to see is a better system for rating bonds.

Correct me if I’m wrong, but don’t many money managers, pension funds, bond funds, etc. have specific rules on what bonds they can hold based on rating? If so, then a ratings downgrade just creates a cascade of selling, which could lead to more downgrades, selling, etc.

So why not just allow the market to determine rating and risk? After all, bond insurers do charge premiums and don’t credit default swaps trade on most of these bonds?

Let’s say the bond market looks something like the chart below, with the x-axis showing how much it costs to insure a bond against default.

I sort of assumed that the universe of bonds might resemble a log-normal distribution where the chance of default for most bonds would be relatively low, with a longer tail of “junkier” bonds. I put my own arrows in the chart just to illustrate my point, but bond managers would be free to pick any point along the distribution that suits their investment objectives.

So if I started a bond fund, I might let my shareholders know that my fund won’t buy (or will sell) any bond with an insurance cost that exceeds X, which would be a certain spot along the continuum at the bottom of the chart. (And yes, I’m referring to “X” as a variable, not as the Roman numeral for “10.”)

This would eliminate one-size-fits-all ratings, providing a bit more flexibility and nuance in setting and monitoring various benchmarks for risk.

I’m sure I’ve oversimplified this, but could it be refined into a workable system? It doesn’t have to be perfect – perhaps a VII on a scale of I to X.