Bond Ratings and Credit Risk

What interest rate a bond must pay to sell depends not only on the current prevailing interest rate, but also upon the issuer's credit rating, an independent gauge by a credit rating agency of the issuer's credit risk (aka bond default risk), the risk that the investor may lose part or all his investment because of the issuer's insolvency or inability to pay interest and principal. The greater the credit risk, the higher the interest rate the issuer must offer to sell its bonds. Moreover, bond prices in the secondary market critically depend on the issuer's credit rating.

Credit ratings may differ for different issues of bonds, even by the same issuer. Bonds secured by assets will have higher ratings. Bonds with higher seniority have higher ratings than more junior issues, which have lower priority in the event of a bankruptcy. Additionally, the issuer may have a general issuer rating.

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 is often leveraged by the issuance of new bonds. The high debt used to make such acquisitions frequently reduces all the issuer's bonds to junk status [see High-Yield Bonds (aka Junk Bonds)].

The top major services, recognized as nationally recognized statistical rating organizations (NRSRO) by the Securities and Exchange Commission, that rate bonds are:

• S&P Global Ratings
• Moody's Investors Service, Inc.
• Fitch Ratings, Inc.
• A.M. Best Rating Services, Inc.
• Check the full current listing: SEC.gov | Current NRSROs

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 called high-yield bonds. Bonds with ratings that begin with C or below are called 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 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.

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 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.

Determining Credit Quality

Different issuers of credit ratings use different criteria to determine creditworthiness and have 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 these financial ratios:

• Liquidity ratios, which include the current ratio, which = current assets/current liabilities, and the quick ratio, which is the same ratio, but with inventory excluded from current assets. Obviously the higher this ratio, the easier it will be for the firm to pay its bills in the short term. Other short-term indicators are cash flow-to-debt ratio (total cash flow/outstanding debt) and the debt-to-equity ratio, which indicates the degree of leverage by comparing how much of a company's assets are provided by creditors over that provided by stockholders.
• Long term indicators are based on the present and past firm's profitability. Such profitability ratios include return on assets, earnings before interest and taxes divided by total assets, and the related ratio, return on equity, net income divided by average stockholders' equity. Interest coverage ratios relate a firm's earnings to its fixed costs that must be paid from earnings. The times-interest-earned ratio = earnings before interest payments and taxes to interest expenses. The fixed-charge coverage ratio includes lease and sinking fund payments + other obligations that must be paid from earnings in addition to interest payments. A higher fixed-charge ratio indicates that the company can likely pay interest.

Companies in different industries have different ratios, so these ratios should be compared to other companies in the same industry.