Learn about Bonds: Credit Rating explained

Credit Rating explained

Credit quality is a measure of the issuer’s ability to service and repay its debt. In the case of gilts, US Treasury bonds and other high-quality government debt, this can be viewed as a certainty. However, for other issuers, the wise investor must do some homework. You may have your own knowledge and views on a company’s ability to repay debt or, alternatively, you can view the credit rating assigned to issuers by several of the credit rating agencies, who deploy considerable resources to assess both the issuer and the individual bond. It is in the interest of bond issuers to obtain these ratings. Without this stamp of approval from an independent body, the bonds will be hard to sell. Indeed, most institutional investors will be unable to purchase a bond that does not have a rating. There are two main international credit ratings agencies, namely Moody's and Standard & Poors. 

Credit ratings are the criteria used by most banks and fund managers when establishing the suitability of a bond as an investment but, remember, situations change quickly, and so can credit ratings. You can look up the rating of most bond issuers on http://www.moodys.com/ and http://www.standardandpoors.com/. An honourable mention should also go to Fitch IBCA (www.fitchratings.com). Much research on this subject is also conducted by broking houses and investment banks, as well as some good up & coming independent analysts. However it is worth bearing in mind that price action in the markets will typically lead any change in the credit rating.

Here is Standard & Poor’s definition of the ratings it awards to organisations issuing bonds (a conversion table for Moodys and S&P is shown on the right):

AAA: Extremely strong capacity to meet its financial commitments. AAA is the highest issuer credit rating by Standard & Poor’s.

Standard & Poors

Moodys
AAA Aaa
AA+ Aa1
AA Aa2
AA- Aa3
A+ A1
A A2
A- A3
BBB+ Baa1
BBB Baa2
BBB- Baa3
BB+ Ba1
BB Ba2
B Ba3

AA: Very strong capacity to meet its financial commitments. It differs from the highest rated obligors only in small degrees.

A: Strong capacity to meet its financial commitments, but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

BBB: Adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

 

The above credit ratings are known as ‘investment-grade debt’. As a rule of thumb, investor’s managing portfolios where the risk must be minimised, and security of income and capital is paramount, will restrict themselves to bonds rated AAA and AA, with perhaps a few single A investments. Consider also a bond’s credit history. Has the rating improved or declined over time? Bonds subject to a potential re-rating will be on ‘credit watch”.

Below BBB: Bonds rated below BBB are known as ‘non-investment grade’. These bonds are of a more speculative nature, and imply a certain degree of risk. In view of this, the incremental yield available on the instrument must be adequate to compensate the investor for this risk. Standard & Poor’s gives the following definitions for non-investment grade debt.

BB: Less vulnerable in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligor’s inadequate capacity to meet its financial commitments.

B: More vulnerable than the obligors rated BB, but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitments.

CCC:Currently vulnerable, and is dependent upon favourable business, financial, and economic conditions to meet its financial commitments.

CC: Currently highly vulnerable.

C: May be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. C ratings will also be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying.

Plus (+) or minus (-): The ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.


Types of issuer

Before we go on to look at some examples of individual bonds and their credit ratings, it is worth considering the different classes of issuer that one might be likely to come across in the Sterling bonds markets:

As a rule of thumb, the bonds with the least risk of default are the high quality sovereign issuers such as the UK and the larger and wealthier European countries such as France and Germany. The risk of default* for bonds issued by these countries can be assumed to be negligible, and lower than the risk from a bank deposit. Ranking alongside these are the Supranationals, these being agencies such as the World Bank and the European Investment Bank which are guaranteed by their sovereign members.  

Second to this are the second-line countries, and those experiencing some economic difficulty. Here we would give Italy and Japan as two examples. While these countries do not quite have the economic strength of some of their peers, it is fair to say that they have a low risk of default. This type of debt should not be confused with emerging market bonds, which may carry a much higher degree of risk. Recent events have propelled some of the more marginal sovereign credits into the highlights, with bonds issued by Greece trading wildly in the markets as investors consider the likely outcome the country's dire financial situation.

Below this we have high quality non-governmental debt. Traditionally the highest scorers are the banks, some of which have credit quality to rival that of a government. However, this status quo has been impacted by the events post-2008

Finally we have Corporate Bonds. These are bonds issued by corporations, typically large quoted companies. The life of a company is full of ups and downs and it is fair to say that in most cases corporate bonds carry a greater risk than those issued by major governments or banks.  Factors affecting a company's credit rating include cash flow, profitability, asset valuations and unforeseen events such as legal action, a takeover or a change of the trading environment. The yield on these bonds will normally be greater than that available on bank debt.

Other types of issuers: There are numerous bonds issued to fund mortgage loans, credit cards loans and other more complex financial transactions. These types of bonds, often known as mortgage-backed and asset-backed are not generally available to the investing public in the UK. We will be covering these types of asset in other articles in this series at a later date. The credit quality of these varies from excellent to poor, typically depending on their place within the "pecking order" of claims to the underlying assets. Secondary market liquidity is often poor.

*Note: risk of default should not be confused with market risk, or price volatility. A bond can be 100% guaranteed by all the governments in the world and still experience price swings between issuance and redemption, typically driven by changing interest rate volatility.


Some sample issuers and their ratings.

Here we have taken a few of the popular issuers

AAA: Germany, France. Supranational agencies such as the World Bank (also know as the IBRD). UK Gilts continue to enjoy a "triple A" status, although this is under review at the time of writing.

AA: Sovereigns such as Japan (AA-). A few high quality banks and corporates

A: Good quality corporates such as Tesco (A-). Lower rated banks.

BBB: More speculative corporates such as Marks & Spencer (BBB-) and British Telecom ( BBB-)

Note: These samples are based on the rating in force at March 2010, and are subject to change.


Frequently Asked Questions

So will a highly rated bond be less volitile than a lowly rated bond? To a degree, yes. The perception of risk will tend to fluctuate less. However, the influence of interest rates, both in the present and to come will exert a similar influence on both highly and lowly rates bonds alike.

What are "junk bonds"? The expression "junk" bond is a colloquialism for a non-investment grade bond, i.e. a bond that is rated below BBB-.  In truth the term junk is often a rather harsh description and the majority of these bonds will live an a useful and uneventful life, servicing both coupons and redemption payments. Nevertheless, a risk of default is implied in the name and caution should be applied when dealing in these assets. At the time of writing, examples of bonds with "junk" status in the Sterling markets include GKN, Manchester United and Cable & Wireless. As might be expected, these types of bonds offer a higher yield to compensate for the additional risk.

Can credit ratings change? Yes, indeed they can. Although the ratings that we follow are described as "long term ratings" by the two main agencies, they can swing around quite quickly as perceptions change. An example of this was the sovereign state of South Korea, downgrade from a comfortable AA- to a worrying BBB- in the late 90's. Needles to say, Iceland was until quite recently rated AAA. Corporate bonds are even more subject to change as their issuers may be impacted by adverse trading conditions. Leveraged takeovers, in particular, can have sudden and disasterous impact on credit ratings.

Please note, the content on this section of the website is provided for educational purposes. Examples shown of prices, yields and credit ratings may have changed since the time of publication.  

Stockcube Research, March 2010