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How much interest a bond has to pay in order to sell is dependent not only on the current prevailing interest rate, but also upon the issuer’s credit rating, which is a independent gauge by a credit rating agency of the credit risk of the issuer. Credit risk (synonym: bond default risk) is the risk that the investor may lose part or all of his investment because of the issuer's insolvency, or inability to pay the interest and principal. The greater the credit risk, the more interest the issuer has to pay to sell its bonds.
Not only does the credit rating of the issuer determine the initial yield of the bond, but it can also affect bond prices in the secondary market if the issuer's credit rating changes. Most often, credit ratings are downgraded, which reduces the price of the issuer's bonds. This is particularly true when the issuer is subject to a leveraged buyout, which, in most cases, is leveraged by the issuance of new bonds. The high debt used to make such acquisitions frequently reduces all of the issuer's bonds to junk status.
The 5 major services that rate bonds are S&P, Moody's, Fitch, A.M. Best, and Dominion Bond Rating Service, and are the 5 nationally recognized statistical rating organizations (NRSRO) selected by the Securities and Exchange Commission. Standard & Poor’s ratings range from AAA for the highest quality bonds to D, which are bonds in default. Moody’s rating system is slightly different, ranging from Aaa for the highest quality down to the lowest rating of C, which characterizes bonds of little or no value. The other rating agencies have similar ratings. Ratings may also have a number or a plus or minus sign next to the rating for a finer distinction within the grade. In addition, there may be a code indicating that the credit rating of the issuer is currently under review, which implies that the rating may change shortly.
All bonds rated BBB or above by Standard & Poor or Baa or above by Moody is considered investment grade; bonds with lower ratings are considered speculative grade, which pays higher interest rates for the higher risk of loss; thus, these bonds are sometimes referred to as high-yield bonds. Bonds with ratings that begin with C or below are referred to as junk bonds, because of their high risk of default. Junk bonds also pay the highest interest rate. Financial institutions and trustees are generally restricted to purchasing investment grade bonds.
Before 1977, most junk bonds were initially issued with a much higher credit rating, but were subsequently degraded because of financial difficulties. However, in 1977, Drexel Burnham Lambert, a junk bond trader, and its star performer, Michael Milken, began the era of original issue junk bonds, issued by companies that could not get an investment grade rating. While the cost of the junk bonds to the issuers was high, it was still cheaper than borrowing from a bank. Many of these junk bonds were used to finance leveraged buyouts and hostile takeover attempts, especially in the 1980's. Today, leveraged buyouts are becoming much more common, and most of these are financed with bonds. One factor leading to more leveraged buyouts is the low cost of junk bonds, which, because of lots of money looking for investment opportunities, has reduced the yield spread between junk bonds and higher credit-quality bonds.
Credit ratings indicate relative risks, not absolute risks. A firm rated AA is less likely to default than one rated B, but there is no indication of absolute risk. However, past default rates can be used as guides, with the understanding that future rates may not equal past rates of default for a given credit rating. And sometimes, credit ratings can be completely wrong, especially when accounting fraud is involved, as was the case with Enron and WorldCom. Enron had an investment-grade rating right up until it declared bankruptcy, and WorldCom up to 3 months before filing for bankruptcy! In fact, WorldCom had issued almost $12 billion worth of bonds in May, 2001 that had an investment-grade rating before it filed for bankruptcy about a year later. Investors in these bonds lost more than 80% of their investment.
Many securities based on subprime mortgages, such as mortgage-backed securities (MBS) and other collateralized debt obligations (CDOs), are receiving downgraded ratings due to the default of many subprime mortgages as interest rates have risen while home prices have been dropping. There are 2 major reasons why many feel that these securities were not accurately rated in the 1st place:
MarketWatch.com: Credit-rating agencies return to crosshairs
Some bonds are not rated because the issuer doesn’t want to pay for a rating, or because the issuer does not have a sufficient credit history for a credit rating. Any bond or note that is backed by the U.S. Treasury is not rated because such securities are considered risk-free.
Issuers of municipal bonds can buy insurance for their investors from companies such as AMBAC, FGIC, and MBIA, which will guarantee payment in case of default. Such bonds generally receive the highest ratings from the credit rating services.
Different issuers of credit ratings use different criteria to determine creditworthiness, and different strengths and weaknesses in rating bond issuers. It would, therefore, behoove an investor in bonds to check several credit ratings before making a purchase.
Most determinations of credit quality are based on the strength and trend of the following financial ratios:
Companies in different industries will tend to have different ratios, and so these ratios should be compared to other companies in the same industry.
Leveraged buyouts, which are becoming increasingly common nowadays and which use the cash flow of the target company to pay off debt obtained to buy the company, frequently destroys the credit rating of the target company, hurting current bondholders. Subsequently, many bond indentures are including covenants which protect bondholders in such scenarios. The most common provision is a change-of-control provision that allows current bondholders to get par value for the bonds from the company when there is a change of control. Although covenants are common in junk bonds, they are relatively rare in investment grade issues, where the credit degradation can be greatest.
Moody's, one of the nationally recognized statistical rating organizations (NRSRO), will assign ratings of CQ-1 for the best protection to CQ-3 for the lowest protection to nonfinancial corporate issuers with a credit rating of Ba to Baa. The rating will include an overall assessment of the covenant protection as well as analysts' commentary.
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