Question

Provide a comprehensive description of the Credit Rating system of Standard & Poors and Moody’s. What type of risk are these ratings supposed to represent? Explain the difference between Investment Grade Debt and Junk Bonds. Of course, lower rated bonds tend to bear higher rates. But, describe how the effect of legal and conceptual arrangements in the United States affect the rates paid on these two classes of bonds.

Answer 1

What is Credit ratings and what is its usefulness:

Credit ratings are one of several tools that investors can use when making decisions about purchasing bonds and other fixed income investments. Credit ratings are opinions about credit risk. Standard & Poors (S& P) and Moody’s are two of the big three ratings agencies (Fitch Group being the third) based in the US, who express their opinions about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time.

These credit rating agencies assign ratings to issuers, such as corporations and governments, as well as to specific debt issues, such as bonds, notes, and other debt securities. Credit ratings speak to the credit quality of an individual debt issue, such as a corporate or municipal bond, and the relative likelihood that the issue may default.

Credit ratings may play a useful role in enabling corporations and governments to raise money in the capital markets. Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes. Investors purchase these debt securities, such as municipal bonds, expecting to receive interest plus the return of their principal. Investors and other market participants consider the credit risk in making their investment and business decisions based on the credit ratings of this agencies.

So now let’s understand what systems S&P and Moody’s follow for credit ratings:

S&P’s process for determining a Credit Rating typically begins with a request for a Credit Rating from the Issuer. S&P Global Ratings provides a Credit Rating only when, in its opinion, there is information of satisfactory quality to form a credible opinion on creditworthiness, consistent with its Quality of the Rating Process. A lot of emphasis is given on sufficient quality information and only after all applicable quantitative, qualitative, and legal analyses are performed, a credit rating is issued. Throughout the ratings and surveillance process, the analytical team reviews information from both public and non-public sources.

Interaction with Management

S&P’s ratings primarily employs fundamental credit analysis, occasionally supplemented by quantitative models in accordance with their criteria. A meeting with management is commonly undertaken as part of the credit rating process.

The Rating Committee S&P Credit Ratings then determine by the vote of a Rating Committee, not by any individual Analyst. Under certain circumstances, S&P Global Ratings issues Credit Ratings that are derived either in whole or in part from other Credit Ratings

Investment Grade example of S&P are –

-       AAA: An obligor rated 'AAA' has extremely strong capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating assigned by Standard & Poor's.

-       AA: An obligor rated 'AA' has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree. Includes:

-       BBB: An obligor rated 'BBB' has adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

-       CCC: An obligor rated 'CCC' is currently vulnerable, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments.

-       CC: An obligor rated 'CC' is currently highly vulnerable.

Moody’s rating process in brief IS along the following lines -

The Moody’s

a)       gather information sufficient to evaluate risk to investors who might own or buy a given security,

b)      b) develops a conclusion in committee on the appropriate rating,

c)       monitors on an ongoing basis to determine whether the rating should be changed, and

d)      informs the marketplace and market participants of Moody’s actions.

The rating committee of Moody’s comprising of a managing director or designated individual and the lead analyst determine the fact gathered and provide an initial rating. The lead analyst for a given company, industry, country, or asset type frames the discussion, including offering the rating recommendation and its rationale. The committee may be expanded to include as many perspectives and disciplines as are needed to address all analytical issues relevant to the issuer and the security being rated. Issues affecting the size of the committee may include the size of the issuer, complexity of the security, geography, or whether a transaction of the type has ever been done before. The discussions of the committees are strictly confidential and only reserved for the senior most panel members of the Moody’s. The committee then arrives as their conclusion. Furthermore, the committee continues to closely monitor the ratings over a period of time and have subsequently maintain or change the ratings periodically based on significant changes or factors that affect their initial decision.

Rating scale of Moody’s run from a high of Aaa to a low of C, comprises 21 notches. It is divided into two sections, investment grade and speculative grade. The lowest investment-grade rating is Baa3. The highest speculative-grade rating is Ba1. SP9108 Long-term Debt Ratings (maturities of one year or greater)

INVESTMENT GRADE example

-          Aaa – highest rating, representing minimum credit risk

-          Aa1, Aa2, Aa3 – high-grade

-          A1, A2, A3 – upper-medium grade

-          Baa1, Baa2, Baa3 – medium grade

The ratings of this agencies in short represents high ratings with minimum risk or high grade with medium risk or lower grade with high risks. And this terms are commonly well know at the market place for the investors to dissect and disseminate the information and use it for the investment purposes.

Difference between Investment Grade Debt and Junk Bonds

As we understand from above ratings play a critical role in determining how much companies and other entities that issue debt, including sovereign governments, have to pay to access credit markets, i.e., the amount of interest they pay on their issued debt. The threshold between investment-grade and speculative-grade ratings has important market implications for issuers' borrowing costs.

A bond is considered investment grade (debt) or IG if its credit rating is BBB- or higher by Standard & Poor's or Baa3 or higher by Moody's. This are bonds that are judged by the rating agency as likely enough to meet payment obligations that banks are allowed to invest in them.Bonds that are not rated as investment-grade bonds are known as high yield bonds or junk bonds.

Rating agencies such as Standard & Poor's and Moody's evaluate the balance sheets of bond-issuing companies and issue ratings based on the company's risk of default. Bonds that receive high ratings are termed investment grade, while bonds that receive lower ratings are classified as junk bonds.

Companies issuing junk bonds must pay higher interest rates, or yields, to bond purchasers to compensate for the increased risk. For this reason, junk bonds are also called high-yield bonds. Hence in short it is said lower rated bonds tend to bear higher rates.

Both the bonds are available in the market place and investors opt to investment regularly in either of them. Investment-grade bonds are a better bet when the economy is faltering and when one is on a cautious note. However, junk bonds are also worth the risk in a period of a strong economy. As an investor one must conduct their own risk/reward analysis to determine which way is best.

In the US, the legal framework to issue bonds is through many routes –

they can be:

·         listed on a stock exchange or

·         issued to a pre-selected group of investors on a private placement basis

·         typically traded over-the-counter (OTC), ie directly between two parties rather than via a stock exchange (even if they are listed on a stock exchange)

Credit ratings of agencies is generally enough for investment grade debt bonds.

However for junk bonds, under the US securities laws, a great deal of additional work goes into their preparation. A disclosure document, or offering memorandum must be prepared which contains detailed information about the issuer’s business, management’s discussion and analysis of financial position and results of operations, risk factors and a description of the notes. The issuer, its counsel, the underwriters and their counsel as well as the auditors are all closely involved in the preparation of the offering memorandum. So with respect to junk bonds besides the rating agencies, a whole lot of other parties are involved for due diligence of the junk bonds being issued in the market place.