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Last week saw two publicly-traded companies lose their AAA credit ratings. That might not sound like a lot … until you realize that there were only seven to start with!
First, Standard & Poor’s downgraded General Electric on March 12. Then, later the same day, Fitch took Berkshire Hathaway down a notch, too.
That leaves just five companies with AAA ratings: Automatic Data Processing, Exxon Mobil, Johnson & Johnson, Microsoft, and Pfizer.
You can see why the mainstream media has been making a major deal out of these credit downgrades. But today I want to give you the scoop on what they really mean, especially if you happen to own either of these stocks in your portfolio …
A Quick Refresher on Credit Ratings
Bond investors are loaning companies money. So their biggest concern is whether they’re going to get their principal and interest back as promised.
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The most common way for them to measure that risk is by looking at a company’s credit rating. Unlike stock ratings or rankings — which come from big investment firms, small one-man operations, and nearly everyone with an opinion — there are really only three major bond ratings agencies in the United States. They are Standard & Poor’s, Moody’s, and Fitch.
There is a raging debate about whether three ratings agencies is enough, especially in light of the current credit crisis. But like it or not, this is the way it is right now.
Moody’s and Standard & Poor’s arguably carry a bit more weight than Fitch, and both firms rate bonds on alphabetical scales, though they use the letters slightly differently. Below is a table comparing the two systems.
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Comparable Credit Ratings from S&P and Moody’s
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Standard & Poor’s *
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Moody’s #
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AAA
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Aaa
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AA
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Aa
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A
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A
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BBB
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Baa
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BB
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Ba
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B
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B
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CCC
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Caa
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CC
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Ca
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C
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C
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D
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* a “+” or “-” on an S&P rating shows relative strength.
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# a 1, 2 or 3 after a Moody’s rating tells you the relative strength of that company vs. others in the same group, with 1 being strongest.
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As you can see, it’s a bit of alphabet soup.
But basically, once you get below ‘BBB,’ you are leaving the world of “investment grade bonds” and entering the realm of high-yield or so-called “junk” bonds. Oh, and ‘D’ pretty much stands for default.
The rest of the letters just represent incremental steps of credit risk — or at least the rating agency’s perception of credit risk. Essentially, they’re guideposts for bondholders who want to answer the all-important question of “Will this borrower pay me back?” And although the ratings aren’t equal to investment recommendations, many borrowers and lenders treat them as such.
It’s important to note just how fallible these ratings can be. Heck, just look at how highly the agencies were rating many of the mortgage-backed securities and collateralized debt obligations a year or two ago. You know … the very same investments that blew up and kicked off our current credit crisis. But I digress.
In most cases, when one of the major ratings agencies downgrades a company, it means the market will be less likely to lend the company money. This ultimately leads to the borrower having to pay higher interest rates.
That makes sense. After all, the likelier you are to pay back the bondholder, the less additional money you should have to pay out over the life of the loan.
A brief side note: In some extreme cases the process can turn into a vicious cycle. In other words, for some companies, a rating downgrade and an ensuing inability to borrow more money may lead to an even weaker business and further credit downgrades. As such, investors should take credit ratings seriously, even those who are holding stocks instead of bonds.
Okay, So What Do These Credit Downgrades Mean for GE and Berkshire?
In my opinion, not a whole lot.
For starters, these moves were widely anticipated. In fact, it seems as though the markets were relieved to see them! Take a look at what happened to GE’s shares after the downgrade … they rallied sharply. Meanwhile, Berkshire dipped just a percentage point or two when the news hit the wires.
When it comes to GE, the real drag has been — and will continue to be — the GE Capital finance unit. That business line is the reason investors have punished GE’s stock so much. But check this out: S&P said even if it had to rate that finance unit as a standalone entity, it would still assign it a single A. Is that really so bad?
I do think the downgrade has further tarnished GE’s “blue chip” reputation. It’s symbolic of just how tough things have gotten. And it highlights some of the risk of investing in the shares. Yet I do not think it — in and of itself — should change anyone’s desire to invest in the company.
What about Berkshire? Well, this downgrade is just another reason for everyone to howl about Buffett losing his touch. But again, it’s symbolic only. Berkshire is sitting on tons of cash, so even elevated borrowing costs wouldn’t be much of a concern.
The main reason for the downgrade does highlight a risk to Berkshire shareholders: Buffett’s big derivatives positions on equity indexes. In a nutshell, he has bet that major stock markets will be much higher 10 and 20 years from now than they are today.
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With levels of pessimism running so high these days, I can see why everyone is so concerned about those bets. And the fact that Berkshire has to mark short-term losses to market makes these investments all the more visible.
Still, I think they will prove wise when it’s all said and done. They have plenty of time to work out. And they have essentially handed Buffett a ton of money to invest in the meantime.
Bottom line: It’s never good to see America’s strongest companies getting their credit ratings downgraded. It indicates just how big the economic challenges are right now.
At the same time, let’s keep some perspective … even after the ratings changes, GE and Berkshire are still a couple of the most credit-worthy firms in the world. And with all the doom and gloom out there right now, I think an AA rating is still something worth celebrating.
Best wishes,
Nilus
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