U.S. Companies Rated AAA, Higher than U.S. Government Bonds
For years the U.S. government was looked to as the gold standard for good credit. Due to its taxing power and healthy finances, it was considered one of the safest investments in the world. Today, that picture has changed somewhat, and now, only two U.S.-based non-financial companies have higher credit ratings than the country itself: Microsoft and Johnson & Johnson.
To gain a better sense of why this is, it helps to understand the factors that underpin the credit rating of a bond issuer. Ratings are assigned by major credit rating agencies such as Standard & Poor’s, Moody’s, and Fitch, and are based on the likelihood that the bond issuer will default, taking into consideration its financial health and future prospects. For instance, the agencies assess factors such as:
- The strength of the issuer’s balance sheet; specifically, its total debt and the strength of its cash position
- Its ability to service its debt via the cash left over after expenses are subtracted from revenue
- Its current business conditions, including earnings growth, profit margins, etc. as well as its future outlook, including the potential impact of industry trends, the regulatory environment, its tax burden, its ability to withstand economic adversity, and other factors.
The agencies rate each issuer on a letter scale based on these and other criteria. The ratings differ somewhat among the three agencies, but the highest ranking–AAA for Fitch and S&P, Aaa for Moody’s–indicates that the borrowing entity is extremely unlikely to default on its debts.
How the Two AAA Companies Gained Higher Ratings than the Government
Due to its rising debt, continued budget deficits and sharply deteriorating debt-to-GDP ratio, the United States is no longer seen as offering the same degree of long-term safety it did even as recently as the late 1990s. From the perspective of its credit rating, the most important event occurred in August 2011, when Standard & Poor’s downgraded the United States debt from AAA to its second-highest rating, AA+.
The primary reason S&P cited for its downgrade was the lower degree of predictability in the U.S. political picture, which raised the uncertainty that wrangling associated with issues such as the debt ceiling.
Alone, the downgrade didn’t have a meaningful impact on the market. The other two agencies retained their high ratings, and even S&P itself distinguishes the difference between AAA and AA as being an “extremely strong capacity to meet financial commitments” versus a “very strong capacity” to do so.
However, the fact that the USA is no longer afforded the highest ranking by all three agencies, whereas Microsoft and Johnson & Johnson both retain that status, means that the two companies are seen as having lower credit risk than the government.
This advantage is justified in the sense that both companies have much better debt profiles than the country as a whole. At the same time, however, the United States has the ability to “monetize” or pay off its debt by printing money, something that of course can’t be said for corporations.
The AAA Rating Isn’t Everything
When comparing the bonds of these corporations to U.S. Treasuries, it’s important to keep a few issues in mind:
- Even though these two companies are more highly rated than the U.S. government, they also continue to offer higher yields since corporate bonds trade at a higher yield than government bonds. This gap is known as the “yield spread.” Since these companies are so financially strong–and therefore at lower risk of default–their spreads are typically lower than the average corporate bond.
- No matter how highly rated the issuer, the performance of its bonds–particularly longer-term issues–are affected by interest-rate risk as well as credit risk. In other words, just because a bond is rated AAA doesn’t mean that the investor is completely safe from the effects of fluctuations in their principal.
- While AAA is the highest rating, bonds rated AA or the equivalent are also extremely safe in terms of the rarity of default. Even though there are only two companies rated AAA, that doesn’t mean that there isn’t an abundance of bonds just outside of this group that are almost equally as safe.
A Final Note
Ratings, while useful, are by no means the only consideration an investor should have when choosing a bond.
On its website, Standard & Poor’s offers the following statement, which is intended as a disclaimer but which is also sound advice: “While credit quality is an important consideration in evaluating an investment, it cannot serve as the sole indicator of investment merit. In evaluating an investment purchase, investors should consider a wide range of factors, including the current make-up of their portfolios, their investment strategy, and time horizon, their tolerance for risk, and an estimation of the security’s relative value in comparison to other securities they might choose.”