Bond Ratings and Credit Risk
How much interest 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 more interest the issuer must pay to sell its bonds. Credit ratings may differ for different issues of bonds, even by the issuer. Bonds that are secured by assets will generally have the highest ratings. Bonds with higher seniority will usually have a higher rating than more junior issues, which have lower priority in the event of a bankruptcy. Additionally, there may be a general issuer rating for the issuer.
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.
The 5 major services that rate bonds are Standard & Poor's, 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.
In August 2016, the Securities and Exchange Commission approved the registration of Morningstar Credit Ratings, a subsidiary of Morningstar Inc., as a nationally recognized statistical rating organization, to provide credit ratings for corporate debt issuers and other financial institutions under the SEC's NRSRO registration.
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 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.
Great Recession of 2008 Exposes More Credit Rating Mismatches
More examples of inaccurate credit ratings have been exposed by the Great Recession of 2008. Most of these exposures to credit risk were through mortgage-backed securities (MBSs) based on subprime mortgages and through credit default swaps. For instance, Lehman Brothers Holdings, Inc. was rated A2 by Moody's and A by Standard & Poor's until it filed for bankruptcy on September 15, 2008. Most of its risk exposure were to MBSs based on subprime mortgages.
The largest U.S. insurer, American International Group (AIG) was also rated A2 by Moody's and A- by S&P when it received an $85 billion loan from the federal government in exchange for an 80% stake on September 16, 2008 to stay afloat. The U.S. government feared that many other financial institutions would be jeopardized if it were not bailed out. It seems that AIG was selling credit default protection through credit default swaps (CDSs) where it received premiums from other financial institutions in exchange for guaranteeing against the default of the MBSs that they held. AIG thought that large-scale default was unlikely, so, the reasoning went, they could just collect the premiums for very little risk. Because AIG had a stellar credit rating, it didn't have to post a lot of collateral to back up its CDSs. However, the CDS contracts required more collateral if their credit rating was downgraded. As the toxicity of the subprime MBSs became evident, AIG's credit was downgraded, requiring them to post more collateral than they had — hence, the need for the government loan.
Credit Rating Agencies Fail to Accurately Rate Securities based on Subprime Mortgages
Many securities based on subprime mortgages, such as mortgage-backed securities (MBS) and other collateralized debt obligations (CDOs), received 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:
- The issuers pay the rating agencies for their rating, which could be a conflict of interest. However, Moody's has stated that, among other things, the analysts who rate the company are not involved in fee discussions. In response to the subprime fallout, S&P is using stricter criteria in rating credit, increasing the frequency of reviews, and modifying its analytical models.
- Another potential conflict of interest is that credit rating agencies also provide consulting for companies on how to increase their rating. For instance, when putting together a CDO, the sponsor will usually consult with one of the credit rating agencies on how the CDO can be structured for the maximum credit rating. CDOs generally need a top investment grade rating to sell their commercial paper in the money market.
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.
Determining Credit Quality
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:
- 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, which = earnings before interest and taxes divided by total assets, and the related ratio, return on equity, which = 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 + any other obligations that must be paid from earnings in addition to interest payments. A higher fixed-charge ratio indicates a greater probability that the company will be able to pay interest.
Companies in different industries tend to have different ratios, so these ratios should be compared to other companies in the same industry.
New Bond Ratings of Covenants by Moody's
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), assigns 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 includes an overall assessment of the covenant protection as well as analysts' commentary.