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Here is an explanation of the Corporate Debt Rating Systems.  The most popular of which is Moody's followed by S&P.  The news often mentions when a large company is upgraded or downgraded by a debt rating service.  The reason these stories are making news is that the company's financial health is being examined.  Downgrades typically mean that based on historical calculations, firms in similar financial condition have been more likely to default on their obligations.  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 to me without a way to determine what "Highest Rating Available" and "Below Investment Grade" means in terms of the likelihood of default on the terms of repayment.  To me, 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 is hard to find a place that shows it.

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.  Zero occurrences!  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.  Doesn't quite seem like Junk to me.

 

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.

You also need to monitor the ratings 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 an 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.  Some people think that an increased interest rate will mean that they will be paid higher interest payments.  That is not the case.  In fact, 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 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 I won't go into those here.

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.  Unfortunately, I do not have the data on their default rates to prove that they are equivalent.  So you and I will have to take the information source's word that they are....

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

 


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