Question

Topic #5: Bond valuation and the structure of interest rates - Text Chapter 6

Case: Select any 2 major credit rating agencies.

Required:

1. a) Outline the differences in approaches / processes between the 2 firms when assessing a debt security rating.

2. b) Why is it generally critical for a bond issue to be rated at least ‘investment-grade’.

3. c) Outline some of the factors that may result in a credit rating agency changing the ratings allocated to a bond subsequent to its issue. Provide a practical example of such re-rating in relation to a bond issue.

Please use the concept of finance to explain this case.

Answer 1

(a)

For a financial institution, ratings are developed based on specific intrinsic and external influences. Internal factors include such traits as the overall financial strength rating of the bank—a risk measure illustrating the probability that the institution will require external monetary support (Moody's implements a scale where A corresponds with a financially healthy bank, and E resembles a weak one). The rating depends on the financial statements of the firm under analysis and the corresponding financial ratios.

External influences include networks with other interested parties, such as a parent corporation, local government agencies, and systemic federal support commitments. The credit quality of these parties must also be researched. Once these external factors are analyzed, a comprehensive overall external score is given. Essentially, this grade is added to the predetermined "intrinsic score" to obtain the overall grade like BBB.

The preceding guideline provides a general framework that Moody's uses in its analysis. Specific bonds, such as hybrid securities, require additional complex analysis, such as the underlying terms of the debt.

Overall, the art of bond rating extends beyond simple ratio analysis and a quick look at a firm's balance sheet. Different measures are used for different industries, and other external influences play a range of roles in the intricate process. A forecasted top-down approach of the overall economic conditions, an in-depth bottom-up procedure of security specifics, along with statistical distribution estimates of the probability of default and loss severity provides investors with a few simple standardized letters to help quantify their investment.

(b)

An investment grade is a rating that signifies a municipal or corporate bond presents a relatively low risk of default. Bond rating firms like Standard & Poor’s and Moody's use different designations, consisting of the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating.

WHY IT IS IMPORTANT

Credit ratings are extremely important because they convey the risk associated with buying a certain bond. An investment grade credit rating indicates a low risk of a credit default, making it an attractive investment vehicle—especially to conservative investors.

Investors should note that government bonds, also known as Treasuries, are not subject to credit quality ratings, yet these securities are nevertheless considered to be of the very highest credit quality.

In the case of municipal and corporate bond funds, a fund company's literature, such as its fund prospectus and independent investment research reports, will report an "average credit quality" for the fund's portfolio as a whole.

nvestment Grade Credit Rating Details

Investment grade issuer credit ratings are those rated above BBB- or Baa. The exact ratings depend on the credit rating agency. For Standard & Poor's, investment grade credit ratings include:

• AAA
• AA+
• AA
• AA-

Companies with any credit rating in this category boast a high capacity to repay their loans; however, those awarded an AAA rating stand at the top of the heap and are deemed to have the highest capacity of all, to repay loans.

The next category down includes the following ratings:

• A+
• A
• A-

Companies with these ratings are considered to be stable entities with robust capacities for repaying their financial commitments. However, such companies may encounter challenges during deteriorating economic conditions.

The bottom tier of investment grade credit ratings delivered by Standard and Poor's include:

• BBB+
• BBB
• BB-

Companies with these ratings are widely considered to be "speculative grade" and are even more vulnerable to changing economic conditions than the prior group. Nevertheless, these companies largely demonstrate the ability to meet their debt payment obligations.

According to Moody's, investment grade bonds comprise the following credit ratings:

• Aaa
• Aa1
• Aa2
• Aa3
• A1
• A2
• A3
• Baa1
• Baa2
• Baa3

The highest-rated Aaa bonds possess the least credit risk of a company's potential failure to repay loans. By contrast, the mid-tier Baa-rated companies may still have speculative elements, presenting high credit risk--especially those companies that paid debt with expected future cash flows, that failed to materialize as projected.

(c)

Bond ratings are vital to altering investors to the quality and stability of the bond in question. These ratings consequently greatly influence interest rates, investment appetite, and bond pricing.

Higher rated bonds, known as investment grade bonds, are viewed as safer and more stable investments. Such offerings are tied to publicly-traded corporations and government entities that boast positive outlooks. Investment grade bonds contain “AAA” to “BBB-“ ratings from Standard and Poor's, and "Aaa" to "Baa3" ratings from Moody’s. Investment grade bonds usually see bond yields increase as ratings decrease. U.S. Treasury bonds are the most common AAA rated bond securities.

Non-investment grade bonds (junk bonds) usually carry Standard and Poor's ratings of “BB+” to “D” ("Baa1" to "C" for Moody’s). In some cases, bonds of this nature are given “not rated” status. Although bonds carrying these ratings are deemed to be higher-risk investments, they nevertheless attract certain investors who are drawn to the high yields they offer. But some junk bonds are saddled with liquidity issues, and can feasibly default, leaving investors with nothing. A prime example of non-investment grade bond was that issued by Southwestern Energy Company, which Standard & Poor's assigned a "BB+" rating, reflecting its negative outlook.

EXAMPLE

Independent Rating Agencies Get Tripped Up In 2008 Downturn

Many Wall Street watchers believe that the independent bond rating agencies played a pivotal roll in contributing to the 2008 economic downturn. In fact, it came to light that during the lead-up to the crisis, rating agencies were bribed to provide falsely high bond ratings, thereby inflating their worth. One example of this fraudulent practice occurred in 2008, when Moody's downgraded 83% of $869 billion in mortgage-backed securities, which were given a rating of "AAA" just the year before.

In short: long-term investors should carry the majority of their bond exposure in more reliable, income-producing bonds that carry investment grade bond ratings. Speculators and distressed investors who make a living off of high-risk, high-reward opportunities, should consider turning to non-investment grade bonds.