Are credit ratings worth the bother?

Put simply, a bond (fixed income instrument) is a financial instrument which relates to a transaction generally between two parties; the investor (bondholder) and the borrower (bond issuer). In other words, a bond is the loaning out of monies whereby investors pool their money to be lent out to bond issuers (the borrowers), more often than not for a finite term and at a pre-determined rate of interest.

It is imperative for a prospective investor to know what the interest rate (return in the form of interest payments on the capital) on a bond is prior to lending out the money. This interest/coupon ultimately determines the periodical coupon payments throughout the duration of the financial instrument, which is also ultimately dictated by the investor’s perception of risk assigned to that type of investment in addition to the general market conditions at the time of issuance. The forces of demand and supply play a critical role here, particularly in the international bond market. Credit ratings are a commonly used measurement of bond risk, both at issuance as well as throughout the longevity of a fixed income instrument. This is the market’s commonly used standard of risk determining the financial strength of a bond issuer, amongst many other crucial factors.

The credit score of a bond issuer and bond issue, through a complex analytical framework, is transposed into a credit rating, via the financial results of a highly complex and detailed and through analysis of the forward-looking credit worthiness of a bond issuer, which is based on the probability or likelihood of a bond issuer defaulting on its debt and financial obligations. A credit rating therefore also takes into account both company specific information as well as other external factors.

Therefore, credit ratings are rankings/scores which a rating agency assigns to each issuer reflecting their (the rating agency) expectations regarding the likelihood of solvency issues (of the underlying bond issuer) which could ultimately lead to an issuer’s failure to honour its financial obligations. Nevertheless, all 3 credit rating agencies use different variations of alphabetical combinations to classify the financial strength of a bond issuer. Examples as follows:

AAA (S&P); Aaa (Moody’s); and AAA (Fitch) – Premium quality bonds

A+ (S&P); A1 (Moody’s); and A+ (Fitch) – High Grade Bonds

BBB (S&P); Baa2 (Moody’s); and BBB (Fitch) – Lower Medium Grade Bonds

BB (S&P); Ba2 (Moody’s); and BB (Fitch) – Non Investment Grade Bonds

B- (S&P); B3 (Moody’s); and B- (Fitch) – Highly Speculative Bonds

Having highlighted the above, we cannot but stress the importance that current and prospective bond investors ought to appreciate that, throughout the lifetime of the bond, yields fluctuate and hence bond prices will reflect the change in market yields, both based on market risks as well as issuer specific risks. Hence, following an upgrade or downgrade by credit rating agencies, or as well as any form of company announcement which indicates that forward looking financial healthy, liquidity and solvency of the issuer, the bond prices (or yields) will adjust to reflect the prospective risks of the bond investor, which primarily is based upon the likelihood or probability that a bond issuer defaults on its financial obligations.

Undoubtedly, credit ratings are a powerful tool for asset managers and investors alike when assessing a company’s credit risk and financial strength/sanity. However, it must be pointed out that one of the key shortcomings of credit ratings is that they do not capture and specify the inherent and relative risks between one bond issuer and another.