Credit Ratings Depend on Size

Sector Credit-Rating Breakdown

Each of the three charts below contains 10 stacked columns. The height of each corresponds to a sector's weight in the designated index, the S&P 500 for large-cap issues, the S&P 400 for mid-cap issues and the S&P 600 for small-cap issues. The columns are sorted by each sector's weight in the designated index.

The blocks within each column correspond to various long-term credit ratings using the S&P credit-rating methodology. This system designates the very best credits as AAA down through various investment-grade ratings to BBB-. In each column, the best credit ratings are on the bottom and the lesser ratings are on top. Issues whose bonds do not have an S&P credit rating are on the top of the stack.

In the realm of fun facts, the S&P 500 is home to America's last six AAA credits. These include ExxonMobil (XOM Quote), Pfizer (PFE Quote) and Johnson & Johnson (JNJ Quote).

The other three names are General Electric (GE Quote), UPS (UPS Quote) and Automatic Data Processing (ADP Quote).

While we are at it, UPS is the second-largest stock by market capitalization in the S&P 500 Industrial sector. That's right, those people running around in the brown trucks stand next to the venerable General Electric in the AAA club and just behind it in the Industrial sector. This says something profound about the landscape of modern American business -- what, I am not sure.

Within the S&P 500, the financials are not only the largest sector, but the one most dominated by A- or higher credits. If any of you are worried about that perennial concern of the perennially concerned -- a global derivatives meltdown -- please note your anxieties are not shared by S&P. This is a tribute to modern financial engineering and risk management, and if that sounds like a trip down Hubris Lane, so be it.

When Long Term Capital Management bit the dust in 1998, it rocked the world. Amaranth Advisors lost more money in a shorter period of time in a narrower trading zone, and the most notable outcome was the hiring en masse by Goldman Sachs of much of its trading team. Yes, we can and will have financial accidents in the future; that's a given. But we appear better equipped than ever to quarantine these developments as they happen.

Click here for larger image.

Source: Bloomberg

The second notable aspect of the S&P 500's credit breakdown is the large nonrated allocation in the information technology sector. We will return to this below.

Middle And Smaller-Capitalization Firms

Now let's take a look at the S&P 400. Here only one firm, WGL Holdings, a gas utility in the Washington, D.C., area, has a rating as high as AA-. A significant number of firms in the consumer discretionary, information technology and health care sectors are below investment grade, and a large number of firms across sectors are nonrated. The credit landscape of middle-capitalization firms is considerably lower than that of the S&P 500.

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Source: Bloomberg

This trend continues as we get into the S&P 600. Here the A's go to utilities, Laclede Group and Piedmont Natural Gas. But the real story is not only the large number of noninvestment-grade issues, but the huge weighting of nonrated bonds across all sectors. The information technology sector typically is financed with equity and venture capital, but the industrial, health care and especially financial sectors elsewhere can tap the corporate bond markets. Size is a gatekeeper to American corporate bond markets.

Click here for larger image.

Source: Bloomberg

Finally, does any of this matter to shareholders in aggregate? The total returns year-to-date for the three market indices in descending order are 15.1%, 10.0% and 14.2%. These results, for 2006 at least, are inconclusive. We cannot say whether investors have been systematically rewarded for taking on greater credit risk or for fleeing it. All we can say is size matters in the corporate bond market.