One of the most important factors in bond selection is its credit rating. Investment-grade bonds go in investment-grade bond funds. Junk bonds go into junk bond indexes, and thus junk bond funds.
In this segment of Industry Focus: Financials, join host Gaby Lapera and Jordan Wathen as they discuss how Moody's, S&P, and Fitch are firmly intertwined in the financial system.
A full transcript follows the video.
This video was recorded on June 26, 2017.
Jordan Wathen: I think that's one of the things that makes credit agencies so important, that they're so intertwined to the financial system that basically, their approval or disapproval over a particular company can really be market-moving. Going back as far as 1934, there was a law that was passed that said banks can only own securities that are investment-grade rated. So, basically, if Moody's, S&P or Fitch at that time did not give you the rubber stamp that says "you are investment grade," then a bank couldn't own your bonds. And by the 1970s, basically everyone was using these credit ratings to decide whether or not a bond is worth owning or even looking into. Actually, I found a quote and I really love it. It was written in 1996, but I think it still applies today. Someone wrote, "There are two superpowers in the world today. There's the United States, and there's Moody's bond rating services. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful." I think that really encapsulates just how important the ratings agencies are to companies that need a rating to issue debt.
Gaby Lapera: Yeah, definitely. It's a really interesting thing. And this is what I was referring to earlier at the beginning of the show when I was talking about how these CRAs can really affect the future of a company. Because you're right, it Moody's is like, "Your bonds are junk," which is a term, junk bonds, that I'm sure most listeners have heard, that means that the bonds are super risky and you have to pay a much higher interest rate on those bonds if you're the company trying to issue them, and people are a lot less likely to buy them, because they don't know that they're going to get paid.
Wathen: Right. This has become even more institutionalized today with the rise of funds, index funds, generally. If you read any bond ETF prospectus, it'll refer to the bond index they use, and the bond index will basically say, "We will only by investment-grade rated bonds that have the rating from Moody's, S&P or Fitch." Nobody else, even though there's more than 10 credit rating agencies. These are the only three that matter.
Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.