Here is an explanation of the Corporate Debt Rating Systems.
Moody's and
S&P are the
largest debt rating services.
The news often mentions when a large company's debt is upgraded or downgraded by a debt
rating service. These stories often make news because the
company's financial health is being examined. Downgrades typically mean
that, based on history, firms in similar financial condition have
been more likely to default on their debt. Upgrades of course mean
the opposite.
Many people are unaware of what the actual debt ratings mean. The
Moody's rating is based on statistical calculations of a company's likelihood of
default. Most explanations give verbal descriptions for the ratings, such
as Aaa = "Highest Rating Available" or Ba = "Low Grade", the
first level of "Below Investment Grade" or the first level of
"Junk Bonds". These descriptions seem useless without a
way to determine what "Highest Rating Available" and "Below
Investment Grade" mean in terms of the likelihood of default on the terms
of repayment. What is important is the chance that the company is
not going to live up to its obligations, and that means the percentage of
companies that default with a given rating. Moody's calculates this
information, but it can be hard to find.
So, here you go. The chart below shows the Moody's Debt Rating system
along with the data that Moody's has calculated for the default rate of bonds
that defaulted within one year of having a given rating for all companies
between 1970-2001. You can see that Aaa means that no company has
defaulted within one year of having an Aaa rating.
You can also see that only 1.21% of companies with a Ba (Below Investment Grade
or Junk Rating) have defaulted within a year of having that rating. This first level of
non-investment grade doesn't quite seem like Junk, at least in the short term.
Moody's Rating
|
Average Default Rate Within One Year of Rating (1970-2001) |
Definition
|
Notes
|
Aaa
|
0.00% |
Highest Rating Available
|
Investment grade bonds.
|
Aa
|
0.02% |
Very High Quality
|
A
|
0.01% |
High Quality
|
Baa
|
0.15% |
Minimum Investment Grade
|
Ba
|
1.21% |
Low grade
|
Below investment grade. "Junk Bonds"
|
B
|
6.53% |
Very speculative
|
Caa
|
24.73% |
Substantial Risk
|
Ca
|
Very poor quality
|
C
|
Imminent default or in default
|
The ratings from Aa to Ca
by Moody's may be modified by the addition of a
1, 2 or 3 to show relative standing within the
category where the highest within the rating is 1 and the lowest is 3.
Ratings also need to be monitored
as they change over time. Just
because a company may have a low chance of
default within one year of a given rating
doesn't mean that their rating can't change, and
rating changes have other market effects due to
the increased or decreased likelihood of
default. The graph below shows the
cumulative default rate of companies based on
their initial Moody's rating at the time the
bonds were issued. The chart above only
shows the Moody rating, and the number of
defaults that occurred within one year of that Moody rating. Below, you can see
that the Aaa Bonds have very low default rates,
even over extended time periods. You can
also see that Ba bonds have a steadily
increasing default rate as the years pass.
Caa-C bonds also have a very large chance of
default over virtually all time periods.
It is obvious that if a Aaa bond never defaults
within one year, as the chart above shows, but
that over time bonds that were initially Aaa
show some defaults at the 15 and 20 year mark,
that they had to have been downgraded at some
point along the way.
Source: Understanding Moody's Corporate
Bond Ratings and Rating Process, May 2002
So, on average how far in
advance do downgrades come before a company
defaults. Obviously for Aaa companies the
answer is, at least one year in advance, since
none of them have defaulted within one
year. To help answer this, Moody's has looked
at its ratings for a number of months before
defaults occurred and determined the average
rating for every time period before a
default. On average, Moody's has rated at
Ba3 up to 60 months before a default. From
there, on average, there are steady downgrades
that typically accelerate in pace as the default
approaches. So, in general there is plenty
of warning before a bond defaults. Usually
it hits Junk status between 3 and 5 years before
the default, but not always, since these are
only averages. Below is a chart that Moody's
calculated showing this.
Source: Moody's, Default & Recovery Rates of Corporate Bond Issuers,
February 2002
There are other reasons to watch
the ratings. Markets react to the
increased or decreased likelihood of default
when a rating changes. In general, the
lower the credit rating, the higher the interest
rate that a given security will have to pay to
entice someone to buy it. It seems that an
increased interest rate will mean that an
investor will be paid higher interest payments.
That is not the case for fixed rate debt. In
this case, the interest coupon payments stay the same,
and the amount someone will pay you for your
bond is decreased. That is the capital risk
involved with credit rating changes. So,
if you plan to hold to maturity there should be
no effect, unless the bond defaults. Of
course, if a bond is upgraded, again the
interest coupon payments stay the same, but the
amount someone will pay you for your bond will likely
increase. Of course there are a whole host
of factors that can lead to gain or loss of
capital in bonds, the most notable is probably
interest rate changes, but that's a different topic.
You can see the effect that credit ratings have on the
interest required for a bond here.
The chart shows the latest Yield Spread for Corporate Bonds over the
Treasury Bond yield for different Credit Ratings. You will see a
dramatic increase in the interest rate required as the rating
decreases. The table is in terms of Basis Points. One basis
point is 1/100th of a percent. So 100 Basis Points is equal to
1%. The Spreads quoted are in addition to the going rate for
Treasuries, which you can find here.
There are a number of other ratings services
available. Below is a chart that gives equivalent ratings
for different rating services.
You should take the time to validate their actual equivalence on your own
before trusting that they really are equivalent....
Equivalent Credit
Ratings
|
Credit Risk |
Moody's* |
Standard & Poor's* |
Fitch IBCA** |
Duff & Phelps** |
INVESTMENT GRADE |
Highest quality |
Aaa |
AAA |
AAA |
AAA |
High quality (very strong) |
Aa |
AA |
AA |
AA |
Upper medium grade (strong) |
A |
A |
A |
A |
Medium grade |
Baa |
BBB |
BBB |
BBB |
NOT INVESTMENT
GRADE |
Lower medium grade (somewhat
speculative) |
Ba |
BB |
BB |
BB |
Low grade (speculative) |
B |
B |
B |
B |
Poor quality (may default) |
Caa |
CCC |
CCC |
CCC |
Most speculative |
Ca |
CC |
CC |
CC |
No interest being paid or bankruptcy
petition filed |
C |
C |
C |
C |
In default |
C |
D |
D |
D |
Source: The Bond Market
Association
* The ratings from Aa to Ca
by Moody's may be modified by the addition of a
1, 2 or 3 to show relative standing within the
category.
**The ratings from AA to CC by Standard &
Poor's, Fitch IBCA and Duff & Phelps may be
modified by the addition of a plus or minus sign
to show relative standing within the category.
Here are Links to more in
depth Information on this subject from Moody's.
Understanding Moody's Corporate
Bond Ratings and Rating Process
Default & Recovery Rates of Corporate Bond
Issuers
Moody's Credit Migration & Credit Quality Correlation
1920-1996
Debt Recoveries for Corporate
Bankruptcies
Testing For Rating Consistency In Annual Default
Rates
An Historical Analysis of
Moody's Watchlists
Predicting Default Rates A Forecasting Model For Moody's Issuer-Based Default
Rates
|