Lesson 8 of 10 · Lessons
Credit Ratings
Understand credit ratings and their role in the fixed income market
CREDIT RATING
What is a Credit Rating?
A credit rating measures a bond issuer’s financial health, its ability to meet its debt obligations. For example, a company with a high rating, such as an AAA rating (e.g. Microsoft), is perceived to be safer than a company with a lower rating, such as BBB (e.g. McDonald’s). Credit ratings are an essential component to any go-to-market debt strategy and will enable issuers to capture a wider range of investor interest and deeper liquidity options.
Demystifying the Rating Scale
| Moody's | S&P | DBRS | Fitch | Rating Description | |
|---|---|---|---|---|---|
| Aaa | AAA | AAA | AAA | Prime | Investment Grade |
| Aa1 | AA+ | AA(high) | AA+ | High Grade | |
| Aa2 | AA | AA | AA | ||
| Aa3 | AA- | AA(low) | AA- | ||
| A1 | A+ | A(high) | A+ | Upper Medium Grade | |
| A2 | A | A | A | ||
| A3 | A- | A(low) | A- | ||
| Baa1 | BBB+ | BBB (high) | BBB+ | Lower Medium Grade | |
| Baa2 | BBB | BBB | BBB | ||
| Baa3 | BBB- | BBB(low) | BBB- | ||
| Ba1 | BB+ | BB(high) | BB+ | Non-Investment Grade Speculative | High-Yield |
| Ba2 | BB | BB | BB | ||
| Ba3 | BB- | BB(low) | BB- | ||
| B1 | B+ | B(high) | B+ | Highly Speculative | |
| B2 | B | B | B | ||
| B3 | B- | B(low) | B- | ||
| Caa1 | CCC+ | CCC(high) | CCC | Substantial Risk | |
| Caa2 | CCC | CCC | Extremely Speculative | ||
| Caa3 | CCC- | CCC(low) | Default Imminent with Little Prospect of Recovery | ||
| Ca | CC | CC | CC | ||
| C | C | C | C | ||
| / | D | D | D | Default |
Credit ratings can be broken down into two categories: investment grade and high-yield. Investment grade issuers are corporations and governments that have strong credit health and excellent ability to meet future financial obligations. Conversely, high-yield issuers are risky investments with significantly higher chances of default.
Global Default Rate: Investment Grade vs. High-Yield
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High-Yield
Investment Grade
Between 1981 and 2014, the global investment-grade default rate was between 0% and 0.42%. In that same period, the global high-yield default rate was between 0.62% and 11.05%.
Rating Agencies
There are a number of private, independent credit rating agencies that offer credit rating services globally. Prominent credit rating agencies include Standard & Poor’s (S&P), Moody’s, DBRS, and Fitch. Although the agencies adopt differing rating scales, there is synchronicity across the scales. For example, an Aa1 rating from Moody’s is equivalent to an AA+ from S&P. In market practice, bond issuers generally obtain and maintain one to three ratings to support their borrowing programs. Obtaining a credit rating usually takes between four to eight weeks, depending on the size and complexity of the issuer.
Rating Outlook: Up or Down?
An important element of an issuer’s credit rating is the rating outlook (positive, neutral, or negative). This is a directional evaluation of where the rating is likely to go over time. In addition, issuers that are expecting major events (e.g. M&A) to occur can be placed on credit-watch, which will highlight the credit rating agency’s view on the impact of the event. According to S&P, an active M&A market in 2015 contributed to an increase of 10 rating downgrades from the year before. Additionally, 57 companies had a negative rating outlook, more than double the positive outlooks.
How is it measured?
Broadly speaking, credit rating agencies focus on two general areas in their rating methodology:
- Business risk evaluates the strengths/weaknesses of the issuer’s operations. This includes market position, geographic diversification, sector strengths or weaknesses, market cyclicality, and competition. This measure allows businesses to be compared against one another to identify strengths/weaknesses.
- Financial risk evaluates the issuer’s financial flexibility, including total sales, profitability, margins, growth expectations, liquidity, funding diversity, and financial forecasts. Most importantly, financial ratio analysis is used to evaluate the downside of the business.
Key Financial Ratios
To a bond investor, financial ratios that address creditworthiness are the most important financial metrics to consider because of the implications they have on a bond issuer’s ability to service its debt obligations. Some important ratios to consider are:
- Leverage: Net Debt/EBITDA, Debt/Total Capital, Debt/Equity Measures how much debt a company has relative to the size of the company’s balance sheet or its earnings potential. A higher leverage ratio relative to peers indicates an extensive use of debt.
- Interest Coverage: EBIT/Interest Expense Measures how easily an issuer can pay interest on its outstanding debt. It indicates the degree of credit protection a bondholder has.
Credit metrics are useful tools to evaluate the downside of any bond issuer, but it’s important to note that they vary from industry to industry. For example, average leverage ratio (Debt/Equity) for the technology sector is 1.2x versus 15.8x for financial services.
Rating Does Not Equal Investing
Although credit ratings are an important metric of a corporation’s financial health, it is not indicative of a strong investment. Credit risk may not reflect other inherent types of risk in a bond, such as market or liquidity risk. Additionally, it is not a guarantee that financial obligations will be met. In general, credit ratings should be used as a supplement to, not a replacement for research and analysis.