Don't Rely on Credit Ratings Alone

Before you buy that next bond, think twice about relying on its credit rating.

By now it's clear the big credit-rating agencies -- Standard & Poor's, Moody's (MCO), Fitch Ratings -- profited during the credit bubble while granting positive ratings to risky mortgage securities. Since companies pay for ratings, the ratings look tainted with conflicted interests. As Rep. Christopher Shays (R., Conn.) recently scolded, "You have so screwed up the ratings as to not be believable."

The problem for investors is the Big Three credit agencies are the main game in town, thanks to high barriers to entry. Just 10 ratings firms are recognized by the Securities and Exchange Commission.

And with stocks down, some high-yielding corporate and municipal bonds look tempting. But given all that's happened, buying even highly rated debt and "insured" muni bonds feels risky. Alabama's Jefferson County, home to Birmingham, is currently trying to avert what could be among the largest municipal bankruptcies in U.S. history. Local areas with high foreclosure rates are also worrisome, as there could be trouble if property taxes fall short of expectations.

The credit firms do concede they need to work at being more "predictive." We couldn't reach anyone at Fitch or Moody's to elaborate beyond recent Congressional testimony, but S&P pointed us to their overall track record: During any given five-year period, for instance, only 0.3% of AAA- or AA-rated corporate bonds fell into default between 1981 and 2006, S&P says.

In fairness, it's not like Congress or regulators did much to prevent the meltdown either. Still, in lieu of wholly trusting credit ratings, there are other ways to research bonds:

Favor General Obligation Bonds

"I believe very strongly that you cannot rely on the credit rating. I never have bought any bonds over the last 28 years based upon the credit agency ratings -- they are always delayed on the upside or downside," says Leslie Beck, a certified financial planner in Cupertino, Calif. For muni bonds, "a good rule of thumb is to start with state general obligations. A state going under is close to the federal government going under so you can't get much safer than that," Beck says.

While you might give up yield, this is a conservative tactic. Also, even for insured muni bonds, check out the underlying credit quality of whoever is backing it. That means…

Stick to Communities You Know

Know the community issuing the bond, advises Tom Balcom, a financial planner in Miami. "Being in Florida, with all the foreclosures, we want to be cautious and diversify among a different variety of states," Balcom says. While he still reviews data from the credit agencies, "in light of the recent developments related to their questionable ratings of mortgage-related securities, our confidence…has been diminished."

Another tip: "Look for necessity-driven muni bonds," says Marc Henn, president of Harvest Financial Advisors in Cincinnati. This means favoring a bond used to raise revenue for, say, a sewer project vs. building a new sports stadium. "Sewers aren't as attractive, but they're something people need."

Treat Corporate Bonds Like Stocks

"Read other stories about the company [issuing the bond], not just Moody's and S&P," says Paul Gifford, manager of the 1st Source Monogram Income Fund (FMEQX). Gifford says he has long used an independent credit-ratings agency, Eagan-Jones Ratings, which charges investors a subscription for their data. "With them not being paid by the corporations you get one step more removed from a conflict of interest," Gifford says.

Also, compare credit ratings to the company's vital signs to see how they match up, including debt-to-cash flow, debt-to-equity and whether revenue has been falling or rising, says Henn.