It is getting more dangerous to buy bonds. This year, there has been an increase in the number of downgrades in credit ratings that far outweighs the upgrades.

The significance of this trend should not be lost on financial advisors, as downgrades are the result of past problems that predict the future prospects for bondholding clients getting paid on time and, eventually, getting their principal back. Bonds’ credit ratings are the canaries in the corporate coal mine – and they are chirping warnings of rising risk.

“More than ever, advisors and investors should look at [bonds’ credit] ratings,” says Graeme Egan, a portfolio manager and financial planner with KCM Wealth Management Inc. in Vancouver. “People are reaching for yield. [Credit] ratings help bond buyers know the risks posed by issuers.”

The trend is worrying. As of Aug. 23, the number of global corporate bond defaults year-to-date matched the number for all of 2011, reports Standard & Poor’s Financial Services LLC. Broken down by region, 29 of the 53 defaulters were based in the U.S.; 14 were in emerging markets; seven were in Europe; and three were in Australasia (excluding Japan). In addition, there was one issue that did not technically go into default but was a suspension of looming interest payments as company finances were restructured; issuer firm was based in Canada.

“The trend toward more downgrades is in line with the trend of the economy,” says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax. “A bond’s [credit] rating allows the investor a magnifying glass into how the economy and other factors are affecting an asset that he [or she] is evaluating.”

Parsing the list of who has failed by rating, it becomes clear that there are good reasons for bond buyers to call high-yield debt “junk.” For the five years ended June 30, an astonishing 43.7% of bonds with “C” ratings (speculative-grade) defaulted vs the category’s 42.6% historical average. The highest default level was in North America, where 48.5% of these speculative-grade issues have flopped.

Corporate defaults do not have the profile of Greece’s restructuring, which saw that country’s sovereign debt downgraded to junk status in April 2010. Greece’s sovereign bond yields rose into the high-40% level and the country was forced out of the capital markets. Still, the number of corporate defaults far outweighs sovereign defaults, which are actually very rare because nations can force bondholders to accept bad deals or take nothing at all.

One high-profile default in the most recent year – that of New York-based commodity dealer MF Global Holdings Ltd. – occurred because of a bad bet on European government bonds. MF Global, which also was a primary dealer in U.S. government securities, had an investment-grade rating prior to the default. However, the firm also had suffered a string of fines from regulators for violating numerous trading and capital rules.

On Oct. 31, 2011, MF Global filed for bankruptcy. The cause was a US$6.3-billion bet that Greece’s and other PIIGS (Portugal, Italy, Ireland, Greece and Spain) nations’ sovereign bonds were underpriced; that bet turned out to be wrong. In fact, the market ruled that these issues were worse than thought at the time MF Global bought them.

The bond prices of PIIGS nations went down, not up – wrecking the long-term position MF Global held. Making matters worse, the firm, which previously had an investment-grade rating of “Ba-1” issued by U.S.-based Moody’s Investors Service Inc. on its debt, used client funds to make up for its mistakes in trading for its own account. The fall from grace was swift: MF Global was insolvent within days of announcing that it had lost billions of dollars. It was the biggest default since Lehman Brothers Holdings Inc. in 2008.

Cases such as MF Global are the visible flames of corporate conflagrations. Most rating downgrades are just shifts from one investment-grade rating to another slightly below, or a move from a non-investment-grade rating to the next one down the ladder. But taken together, rating changes show significant trends in credit quality.

At Toronto-based credit-rating agency DBRS Ltd., 9.8% of the issues it rated in the nine months ended Sept. 30 were downgrades; that’s more than 16 times the 0.6% of the credit ratings DBRS upgraded.

“What we have seen this year is a virtual absence of upgrades, while the downgrades line up with historical averages,” explains Peter Schroeder, managing director and co-head of corporate ratings with DBRS in Toronto. “One of the areas that showed downgrades – natural gas exports – reflects weakness of gas pricing.”

Credit ratings are snapshots of the past rather than pictures of the present. Yet, for advisors and portfolio managers, bonds’ credit ratings cannot be ignored, says Marc Stern, vice president and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal.

“The rating agencies are no longer as accommodating to firms that pay their bills for [credit] ratings,” Stern says. “[The agencies] have been casting a more critical eye on issuers’ fundamentals. An argument can now be made that more reliance can be placed on [the agencies’] judgment.”

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