Credit rating agency

A credit rating agency provides independent assessments, in the form of credit ratings, of the probability of default of companies, governments and the providers of of a wide range of financial instruments. Credit ratings have major impact on the availability and cost of credit for borrowers.

The two top bond-rating agencies in the industry are Moody’s and Standard and Poor’s (S & P), although there are other rating agencies such as Fitch, Pacific Credit Rating, Baycorp Advantage, and Dominion Bond Rating Service. These agencies rate the bonds of corporations by assigning them different letter codes. Moody’s and Standard and Poor’s for the most part have the same ratings but the numbers are different. For example, S & P rates AAA as the best type of bond and C as the lowest, while Moody’s rates Aaa as being the highest and D as the lowest. The different letter codes represent bonds which are of investment quality and bonds which are considered low quality, also known as junk bonds. Investment grade bonds are those which are rated higher than Baa (Moody’s) or BBB (S&P) and are considered to be of high quality. These bonds have the lowest amount of risk because the company is in good financial health. Junk bonds are the lowest rated bonds and have ratings of Caa/CCC or lower. These bonds have a great amount of risk involved because even the future in the short-term for these companies is uncertain.

The rating process begins when a company submits an application to the rating agency such as Moody’s, Fitch, or S&P. The request for a rating is usually made several weeks before the company is ready to issue new bonds. In order for the rating agencies to perform their review and analysis, they need to be provided with certain documentation. This includes the preliminary official statement, last audited and unaudited financial statements, the latest budget information, capital outlay plans, all legal documents relating to the security for the bonds, and any other documents related to the issuance of the bonds. After the analysis has been completed a credit report is presented before a rating committee and a rating is assigned and released to the issuer.

Bond ratings also affect the bonds yield or the amount of return that an investor can expect on the bond. A bond which is highly rated typically has a lower yield because the issuer does not have to offer a high coupon rate in order to attract investors. This is because the high bond rating tells the investor that the company is less likely to default than most other companies. A bond which is rate lower typically has a higher yield because investors demand extra incentive to compensate for the higher risk which is involved. This extra incentive comes in the form of default risk premiums. Default risk premiums are an additional amount that borrowers must pay in order for investors to assume the higher risk. Since 1970, an average of 3.45% of speculative-grade issuers have defaulted per year, compared with just 0.05% of investment-grade issuers. Since 1983, average one year default rates rose from 0.0% for Aaa to 12.2% for B3.

Bond ratings are important because companies do default and when they do investors can lose a lot of money. There have been instances where companies have defaulted on hundreds of millions worth of bonds. AmeriServe Food Distribution Inc. defaulted on $200 million in junk bonds leaving investors with a loss of $160 million. Bond ratings are essential to the investor because they are an indicator of the default risk involved in purchasing certain bonds. With the ratings investors can make informed decisions on whether or not to purchase certain bonds.

Comparing different rating agencies Ratings S&P Moody’s Default Rate% Highest Quality AAA Aaa .52 High Quality AA Aa 1.31 Upper Medium Quality A A 2.32 Medium Grade BBB Baa 6.64 Somewhat speculative BB Ba 19.52 Low grade Speculative B B 35.76 Low grade default possible CCC Caa 54.38 Low grade partial recovery Possible CC CA 59 Default recovery unlikely C C 60

http://www.moodyskmv.com/research/whitepaper/52453.pdf go to this website. This website compare the historical yields for 5, 10 15, and 20 default rate.

Robert Brokamp (2008) “What is a Bond?”

Alex Tajirian (2007) “Cost of Borrowing & Rating Agencies”

Chris Stallman (1999) “Bond Ratings

Bill Lockyer (2007) “The Credit Rating Process” Fidelity Investments http://personal.fidelity.com/products/fixedincome/bondratings.shtml Moody’s http://www.moodyskmv.com/research/whitepaper/52453.

Ross, Westerfield, & Jordan (2008) Essentials of Corporate Finance

Works Cited List

1.Ross, Westerfield, & Jordan. (2008). Essentials of Corporate Finance (6th ed.) McGraw-Hill/Irwin

2.Chris Stallman (1999). Bond Ratings. Financial Content. http://www.teenanalyst.com/bonds/bondratings.html

3.Bill Lockyer (2007). The Credit Rating Process. Public Finance Division. http://www.treasurer.ca.gov/ratings/process.csp

4.Robert Brokamp (2008) “What is a Bond” Bond Center http://www.fool.com/bonds01.htm

5.Alex Tajirian (2007) “Cost of Borrowing & Rating Agencies” Finance Channnel http://beginnersinvest.about.com