Many stock investors never pay any attention to bond ratings. But a company's creditworthiness has a direct impact on its bottom line, and if you can find companies that are in line to get a boost to their ratings, it can translate into lower costs and more profits for shareholders.
Below, I'll talk about some companies that appear to be in line to get credit upgrades that should cut their interest expenses and make them more attractive to investors. First, though, let's take a quick look at how bond ratings work and why certain ratings are more important than others.
The ABCs of bond ratings
Several companies, including Standard & Poor's, Moody's, and Fitch Ratings, provide bond ratings on companies as well as individual bonds. The way they express their ratings differs slightly, but the ratings agencies share similar meanings.
The top rating available is AAA in S&P nomenclature or Aaa at Moody's and indicates, in S&P's words, "extremely strong capacity to meet its financial commitments." Going down the scale, AA, A, and BBB demonstrate "very strong," "strong," and "adequate" ability to repay debt respectively. Except for AAA, a "+" or "-" further refines the letter rating. For Moody's, the analogous ratings are Aa, A, and Baa, with the number 1, 2, or 3 giving additional refinement of the rating, 1 being the highest portion of the category.
What's at stake
But one particularly important line in the sand for companies is the gap between investment-grade ratings and speculative-grade ratings, also known as high-yield or junk bond ratings. Although the distance between BBB- and BB+ or Baa3 and Ba1 may seem no more significant than any other one-notch disparity, it can make a huge difference in the way investors perceive the company and price its bonds.
As a result, every junk-rated company wants to claw its way back to investment-grade status. When Ford (NYSE: F) finally got a bond rating upgrade from Moody's in May, it not only represented the end of a nearly seven-year-long spell, but also allowed the company to reclaim its blue-oval logo, an asset that it pledged as collateral. Similarly, Southwestern Energy (NYSE: SWN) finally earned its investment-grade colors in February after spending nearly 10 years in junk status.
Who's next?
One place to look for upgrade prospects is at companies with BB+ ratings that have a positive outlook. HollyFrontier (NYSE: HFC) is one such company, having gotten a revision to a positive outlook from S&P just a month ago. Since then, the refiner has seen its shares jump 10%, although that's come in a generally strong environment for refiners as oil prices have come down faster than those of refined products.
Pioneer Natural Resources (NYSE: PXD) is another possible candidate, with Fitch having rated its new 10-year notes at BB+ with a positive outlook. With an optimistic production outlook and a healthy reserve base supported by a sizable hedging program, Fitch felt comfortable granting the rating.
How to play potential upgrades
The problem with looking at bond upgrades as a catalyst is that most investors are already aware of the strategy. For instance, even before Starwood Hotels (NYSE: HOT) returned to investment-grade status this year, its bonds already yielded the same as investment-grade bonds of other companies. Similarly, Ford's shares have declined in a poor market environment since the upgrade, and Southwestern Energy is battling with weak natural gas prices that have also hurt the stock.
As a result, investors shouldn't count on a potential bond upgrade giving them an immediate short-term pop. Rather, it's a signal that a company has improving long-term prospects -- and the payoff could well come years down the road.
Even if you're primarily a stock investor, you should keep your eye on the bond market and other financial markets. Often, those other markets have a big impact on the stocks you own.
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