Should Dividend Investors Look At Credit Ratings?January 29th, 2013 by Marc Prosser
Dividend investors should definitely look at a company’s credit rating before they invest in the company’s stock. In many cases, the credit rating provides valuable insight into the company’s ability to continue paying a generous dividend in the future. If your top investment priority is the stability of a company’s dividend, Learn Bonds’s recommends avoiding companies with a credit rating of below A-.
What do credit ratings measure?
Credit ratings seek to quantify the probability that a company will be able to meet its debt obligations, including the payment of principal and interest. Credit ratings tend to focus on the question, “What could go wrong for the company?.” While stock analysis also asks this question, they are equally or more interested in the potentially upside. Credit analysis puts more emphasis on negative scenarios and their impact on the ability to pay bondholders.
If under certain scenarios a company will not be able to pay its bondholders, then the company will not be able to pay a dividend to its stockholders. Legally, a company’s first obligation is to its bondholders. A bad credit rating means that a company has a high probability that it may have to lower or eliminate its dividend in the future.
The reverse is not always true. A strong credit rating does not necessarily mean that a dividend is safe. We will explore this in detail later in article.
Where do you find credit ratings and how do you interpret them?
There are a handful of companies that provide credit ratings, however, there are only two which matter: S&P and Moody’s. While each company does their own analysis, the ratings produced by the two companies are very similar. The highest possible credit rating is AAA. However, any credit rating that starts with the letter “A” is considered very good. Ratings that start with a “B” are a mixed bag and those that start with “C” are considered to have a very high risk of default. For a more in depth explanation see our credit ratings table here. All the major brokerage firms provide free access to rating reports for their account holders. For example, TD Ameritrade offers access to reports from Moody’s. Join TD Ameritrade. Trade free for 60 days + Get up to $600For more on how to use corporate bond credit ratings in your investment decisions go here.
Over 10 year periods, companies that started with an A rating (including A+,A, A-) defaulted on their debt 2.18% of the time. However, when looking at the next level down BBB (BBB+, BBB, BBB-) the default rate rose to 5.9%. As you can see, there is a big difference for the default rate for these ratings. While it doesn’t say what percentage of the companies cut their dividends, we know that every company that defaulted stopped paying a dividend.
Does a high credit rating like AAA or AA mean that a company’s dividend is safe?
No. There are two reasons why a great credit rating can be misleading:
A) The company has a small amount of debt compared to its size. For example, Exxon Mobil has a market value of over $400 billion with less than $13 billion of debt. Even if the company hits very hard times, the debt is so small compared to its assets that it will have no problem paying it. Its ability to pay debt is not a reflection on the economic health of the company. As a rule of thumb, I would say that the credit rating will be misleading if the debt is less than 25% of the company’s market cap.
B) The company has such a large dividend payment (in terms of dollars) that its ability to pay its debt does not mean it can continue to pay its dividend going forward. For example, Johnson & Johnson (JNJ) pays out $6 billion a year in dividends, however, has $17 billion of debt obligations due over next 30 years. Put another way, the company could retire all of its debt for the cost of 3 years of dividend payments. As a rule of thumb, I would say that the credit rating is misleading if the annual dividend payment is more than 20% of the face value of the company’s debt.
With these two important caveats, I think a high credit rating is a good indication of a company’s ability to pay its dividend.