Question: What do you think about bond ratings? Should I use them?

A BuyandHolder

Dear BuyandHolder,

Bond ratings are a good place to begin but recent controversy regarding their total reliability indicates the importance of using other approaches when evaluating bonds to add to your portfolio.

The “big three” in the bond rating field are Standard and Poor’s, Fitch and Moody’s. The fourth player is A.M. Best.

The ongoing negative publicity about these rating companies stems from the fact that they gave high ratings to real estate-backed securities that, as we all know, plunged in value as the housing market collapsed.

Criticism came even prior to that when Enron and AIG were highly rated even as these two giants faced insolvency.

Why the problem? Basically it stems from the fact that the credit rating agencies are paid by the firms that issue the bonds and not by investors or a non-profit group. This is said to create a conflict of interest. In other words, the agencies are rating clients who are paying them. This in turn, critics maintain, encourages them to relax rating standards in order to secure more business.

A possible solution

The National Association of Insurance Commissioners (www.naic.org) announced recently that it is considering creating its own non-profit rating agency. FYI, the NAIC is the organization of state insurance regulators for all 50 states, Washington D.C. and the five U.S. territories.

Incidentally, you will find several helpful brochures on the NAIC website (in the “consumer” section), covering such topics as auto and home insurance.

What to do

(1) Despite the current criticism surrounding the agencies, you certainly want to check bond ratings for any investments you’re considering. Although you may want to be cautious about A ratings, you can obviously be more confident in ratings below A, and you should steer clear of those bonds.

(2) Always read the issuer’s annual and quarterly reports. Specifically, look at the company’s debt level – if it’s high, stay away. Ditto if there are significant ongoing legal problems.

(3) In order to further cut your risk, instead of investing in one or two individual bonds, purchase shares in a bond mutual fund. Their diversity obviously reduces the impact of any one company’s financial failure.

BUYandHOLD offers money market funds. For details, click HERE.

(4) Finally, if you find it difficult to make sense out of the financials in annual reports – which is true for most people – I recommend getting a copy of “Reading Financial Reports for Dummies.” It makes it almost easy! Details at: www.dummies.com.