13.6 Credit Ratings
Corporations are rated by credit-rating agencies that assess a corporation’s ability to service its debt (i.e., to pay interest and principal in full and on time) and, thus, to avoid a default and to ultimately keep bankruptcy at bay. This is a risk, which may also be referred to as “default risk.”
We have already examined three solvency ratios which attempt to provide some insight into this risk. Clearly, there are many more tools and considerations that enter into the process of credit analysis and rating. Companies must pay for this service, but not all do so, as some bond issues are too small to justify the expense, while others may be sold directly to institutional investors and thus do not require a rating.
Today, there are two major rating agencies: Standard & Poor’s (S&P) and Moody’s. Fitch is still a third agency, but it does not enjoy the market presence of the others. In addition, there are numerous nationally recognized statistical rating organizations or “NRSRO’s” that perform similar functions (see: https://www.sec.gov/ocr/ocr-current-nrsros.html). The agencies rate bonds on the scale illustrated below. As you will note, there are some differences in the rating scales, and, although not visible in the ratings themselves, the manners in which the agencies conduct their respective analyses and what they consider important also differ from one agency to the other. As a result, the agencies may not rate the same bond issuer the same.
Within each rating category, the agencies may append additional notation, such as “A-” in the case of S&P. This provides some further refinement to the ratings.
Note:
Ratings will clearly affect the bond’s yield – in inverse relation to the rating, with lower ratings generally bringing higher yields. That is to say that the lower the credit rating, the higher the default risk. A greater default risk means a lower dollar price, which, in turn means a higher yield.
The better the bond’s initial rating, the lower the bond’s coupon rate of interest, and, of course, the lower the issuer’s cost of debt capital; this is also true for the bond’s subsequent secondary market yield, (a.k.a. yield-to-maturity; YTM). Do not confuse coupon and market yields; they are separate. The coupon determines how much the interest bond pays, whereas the YTM is the ever-changing market discount rate which is used to price the bond.
The rating agencies do not collude or necessarily agree with one another; in some cases, the agencies may rate the same company somewhat differently. Interestingly, the bond market itself seems to understand what the true yield for a bond should be; indeed, yields often adjust long before a rating change (i.e., either an upgrade or a downgrade) announcement. Further, a bond’s rating is not necessarily “correct.”
In the case of municipal bonds, the agencies conduct similar analyses and provide similar ratings. The interpretation of municipal ratings, however, is somewhat different in pr