Almost all public or quasi-public debt issues must be rated by a credit rating agency, which are firms that specialize in credit analysis and may have access to information which a general investor or shareholder might not have.
Credit ratings have become popular with growth in debt markets, primarily because: (a) they do an independent analysis of risk, (b) they make a comparison between debt easier, (c) are acceptable for regulatory and statutory purposes, and (d) their cost is borne by the issuer. In the aftermath of the 2008-2009 crisis, new legislation is introduced
Credit rating nomenclature
Following are some of the features of the credit rating nomenclature:
- Triple-A (Aaa or AAA) rating has the highest credit quality and minimal credit risk.
- Double-A ratings are of high-quality grade, with very low default risk.
- A-ratings are referred to as the upper-medium grade.
- Bond rates Baa or BBB are referred to as the lower-medium grade.
- Rating Baa3 (Moody’s) or BBB− or higher represent investment-grade debt.
- Bonds rated Ba1 or BB+ and lower have speculative credit and increasingly higher yield. These are collectively referred to as non-investment grade, high-yield, or junk.
- D rating represents bond issues that are already in default.
Rating agencies also provide information about their outlook—positive, stable or negative, and potential director of their rating (in certain circumstances) i.e. on review for downgrade, on CreditWatch for an upgrade, etc.
Issuer ratings vs issue ratings
Rating agencies issue two types of ratings: (a) an issuer rating (also called corporate family rating), which assesses general creditworthiness of the issuer and generally applies to its senior unsecured debt, and (b) an issue credit rating (called corporate credit rating), which relates to a specific bond issued by the company. Even though the cross-default provisions, where default on one bond means default on all bonds, implying the default probability is constant, a rating agency considers factors such as ranking in the capital structure to rate an issue rating differently from an issuer rating through a process called notching.
For credit rating, default risk (the likelihood of default) is the primary consideration, but as the default risk increases, priority of payment in the event of default and loss severity becomes important. Structural subordination occurs when in a holding company setup, cash flows and assets of operating subsidiaries are first used to pay subsidiaries’ debt. These factors cause an issue rating to change a notch or two up or down from the issuer rating. This process is called notching and it is more visible in lower-rated credits.
Risks in relying on agency ratings
Despite a few exceptions during the financial crisis of 2008-2009, rating agencies have done a good job are assessing credit risk which is why they are very popular. However, they are prone to limitations:
- Credit ratings can change over time: Even though high credit ratings are more stable, only about 70% of AAA-rated bonds maintain the same rating over a three-year period, which shows that creditworthiness does change over time and that debts do not necessarily maintain the rating they get at the time of issuance.
- Credit ratings tend to lag the market’s pricing of credit risk: Evidence suggests that bond prices and credit spreads are much quicker than credit ratings (or even their outlook) in pricing risk. This is because bond prices change daily while credit ratings are updated less frequently. Further, in case of non-investment grade debt, two bonds with the same rating may trade at very different valuations. It is because credit ratings focus on default risk while market prices reflect expected loss.
- Rating agencies may make mistakes, particularly where there is accounting fraud, etc.
- Some risks, such as litigation, etc. are difficult to capture in credit ratings.