Exxon Mobil and Credit RatingsSubmitted by Headwater Investment Consulting on June 1st, 2016
By Kevin Chambers
At the end of April 2016, the most prestigious club in the world of finance got even smaller. Exxon Mobil, faced with sustained low oil prices was stripped of their AAA rating by Standard & Poors. Exxon Mobil attained their AAA rating in 1949, at the beginning of S&P. S&P now ranks Exxon Mobil at AA+, just one step down from their top rating. With this change in Exxon Mobil’s rating, only 2 companies remain rated as AAA rated companies, Microsoft and Johnson & Johnson. The previous member to be booted from the AAA club was ADP when it was downgraded in 2014 (Ailworth, 2016).
What is a Credit Rating?
Credit ratings are given by private companies; S&P and Moody’s are to two most well-known credit rating issuers. Credit ratings indicate how likely the company is to pay back their debt. Companies issue debt in the form of bonds. Similar to IOUs, bonds are essentially loans sent out to the public market instead of from a bank. Credit ratings are comparable to the credit score assigned to individuals, except concerning companies and governments.
We will use S&P for our discussion as Moody’s uses a slightly different scale. The scale runs from AAA at the top down to D at the bottom. Companies at the top have a very low risk of default. A company or country with a high rating usually has a lower interest rate than a high-risk company. Investors require higher payment to take on the added risk of a possible default. Any bond below BBB- or with a C or D rating is labeled as a “junk bond” and considered very risky. Bonds higher than BBB- are defined as “investment grade.” Credit rating is an important indicator when deciding to invest in a bond.
Credit Ratings in Our Portfolios:
Our clients have exposure to corporate bonds through bond mutual funds. We look at the average and the distribution of the credit rating of all the bonds in the product to analyze the overall risk. Many mutual funds make it clear in their name what type of bonds they invest in. For example, the Vanguard Intermediate Investment Grade Bond Fund (VFIDX) invests in only investment grade bonds. This is indicated by an average quality of A with 80% of the bonds rated A or above. High-quality bond mutual funds make up the majority of the bond positions in our client accounts.
However, due to the higher yields available, some of our clients also have small positions in lower rated bonds. Mutual funds that invest in lower-quality bonds are often called “high-yield” bond funds, which is easier to market than “risky.” As an example, let’s look at the Vanguard High Yield Corporate Bond Fund (VWEAX). For this fund, the average credit quality is B and 95% of the bonds are B or lower. Both of the funds we have mentioned have a similar duration (the other main indicator of risk for bonds). The high-yield fund has a yield of 5.7% vs. 3% for the high-quality fund. Although the risk may not be for all investors, the attractive yield can make it worth it for some. Some of the risk is mitigated through the mutual fund’s diversification. VWEAX holds over 400 bonds.
Understanding credit ratings are a good exercise for investors as bonds hold important places in most portfolios, and ratings are the quickest way to determine their risk.