Bond Ratings

Mitchell Dietrich
BA 543
May 12, 2005
What are Bond Ratings?

A bond rating is an opinion of the

ability of issuer to honor their
financial obligation to make
coupon or principle payments.

The higher the rating the less likely

an issuer will default.
Who issues bond ratings?
• Moody’s Investor Services
• 1909 – John Moody published a book of Railroad
Investments that included concise analysis of their
relative investment quality.
• Standard & Poor’s Corporation
• 1860 – Henry Varnum Poor began supplying
European investors with financial information on their
holdings in the developing infrastructure of America
• Fitch Ratings
• 1913 – John Knowles Finch published “Fitch Bond
Book” and other books on financial markets. Fitch is
credited with introducing the AAA through D rating
system now used
Comparison of Bond Ratings
Investment Grade Bonds
• Highest Grade - AAA These bonds are judged to be of the best quality.
They carry the smallest degree of risk. Interest payments are protected by
an exceptionally stable margin and principal is secure.  The issuer’s
capacity to meet its financial obligation on the bond is extremely strong.   

• High Grade – AA These bonds are judged to be of high quality by all

standards. Margins of protection may not be as large as in AAA securities.
 The issuer’s capacity to meet its financial obligation on the bond is very
strong.   

• Upper Medium Grade – A These bonds possess many favorable

investment attributes. Factors giving security to principal and interest are
considered adequate.   Although these bonds are somewhat more
susceptible to the adverse effects of changing economic conditions, the
issuer’s capacity to meet its financial obligations is strong.   

• Medium Grade – BBB The bonds lack outstanding investment

characteristics and have speculative characteristics as well.   Adverse
economic conditions are more likely to lead to a weakened capacity of the
issuer to meet its financial commitment.
 
Speculative Grade Bonds
• Distinctly Speculative Grades- BB & B
The future of these bonds cannot be considered as well
assured. These bonds face exposure to adverse business or
economic conditions which could lead to an issuer’s
inadequate capacity to meet its financial commitment.   

• Predominately Speculative Grades- CCC and below

These bonds are of poor standing. Such issues may be in
default, or there may be elements of danger with respect to
principal or interest. These bonds are vulnerable to
nonpayment, and are dependent upon favorable economic
conditions for the issuer to meet its financial commitment.
Estimated Default Probabilities
Short Term Ratings

Short-term ratings are opinions of the ability of issuers to honor short-

term financial obligations. Ratings may be assigned to issuers,
short-term programs or to individual short-term debt instruments.
Such obligations generally have an original maturity not exceeding
thirteen months, unless explicitly noted.

Investment Grade
P-1 Issuers rated Prime-1 have a superior ability to repay short-term debt
obligations.
P-2 Issuers rated Prime-2 have a strong ability to repay short-term debt
obligations.
P-3 Issuers rated Prime-3 have an acceptable ability to repay short-term
obligations.

Speculative Grade
NP Issuers rated Not Prime do not fall within any of the Prime rating
categories
Why are ratings important to Issuers?
Why are ratings important to Issuers?
• They are independent verification of their credit
worthiness.

• They allow the issuers to “tell their story.”

• They are a marketing tool that can be used to

attract investors.

• The higher the rating, the lower their borrowing

costs.

• Provide potential investors with an unbiased

opinion regarding their ability to meet obligations.
Why are ratings important to Investors?
Why are ratings important to Investors?
• They rely on ratings as an indicator the risk of
default for a particular bond investment.

• The ratings influence the price and the yield of a

bond

• The rating provides investors with comparative

ranking between bonds that they would otherwise
be either impractical or impossible for them to get
with their own resources.
Rating Process
1. Bond Issuer requests that a rating company
determine a rating.
2. Rating Company forms an analytical team that:
– gathers information sufficient to evaluate risk to
investors who might own or buy a given security.
– develops a conclusion in committee on the appropriate
rating
3. The Rating Committee then issues a rating
decision based on the report of the analytical
team.
4. The new rating then is monitored over time and
adjusted as appropriate to reflect changes in the
probability the issuer will default.
What information is used in
determining a bond rating?
What information is used in
determining a bond rating?
• Publicly available data, e.g., annual reports.
• Prospectuses, offering circulars, offering memoranda, trust
deeds, or indentures of particular securities.
• Market data, e.g., stock price trends, trading volume, data on
bond price spreads.
• Economic data from industry groups, associations or bodies,
such as the World Bank.
• Data from agencies, such as central banks, ministries, or
regulators.
• Books or articles from academic sources, financial journals,
news reports.
• Discussions with expert sources in industry, government, or
academia.
• Data that may come from meetings or conversations with the
debt issuer.
What information is used in
determining a municipal bond rating?
What information is used in
determining a municipal bond rating?

• Stability of tax base

• Demographic Factors
– growth of population
– Financial capacity of population

• Governmental Factors
Rating Changes
• Rating are adjusted as likelihood of default
is upgraded or downgraded
– Issues which are being reviewed for possible
changes are placed on a credit watch list

• Ratings are much more likely to be

downgraded because of:
– Event risk
– Leveraged buyout or recapitalization
– Other reasons – Fallen Angels
Ratings Transition Matrices
What happened to Ford and GM?

•
Ford – The downgrade to non-investment grade (BB+ from
BBB-) reflects our skepticism about whether management’s
strategies will be sufficient to counteract mounting
competitive challenges. (S & P )

• GM – The downgrade to non-investment grade (BB from

BBB-) reflects our conclusion that management’s strategies
may be ineffective in addressing GM’s competitive
disadvantages..... The effort by Kirk Kerkorian’s Tracinda
Corp. to increase its ownership stake in GM represents an
additional uncertainty; however this is not a factor at all in
the current rating action. (S & P)
Questions?