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Bonds
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Type of Yields
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Bond Rating Agencies
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The Yield Curve
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Laddering
Types of Bonds
- Corporate Bonds
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Municipal Bonds
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Asset Backed Securities
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High-Yielding Securities –
Junk Bonds
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Enhanced Trust- Preferreds
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Zero-Coupon Bonds
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STRIPS Bonds
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Internotes
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International Bonds
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Brady Bonds
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Bond Rating Agencies
Bond rating agencies
review a company’s credit worthiness to determine if a company can repay its
debts in a timely fashion. They then grade the company. The rating system is
clearly explained and the agencies try to make the reasons behind the rating
decisions as transparent as possible. Normally, the CFO of an organization
coordinates with the rating agencies, to supply all proper documents and to
answer the boiler plate questions. The rating agency meets with the
management, clients, bankers, and suppliers, to properly grade the company.
Yes, there is some “wheeling and dealing” involved, but at the end of the
day, these agencies are extremely diligent and will not jeopardize their
reputation and business, for a few dollars. They also have other sources
of revenues, like subscription based services, so most clients are not
material. Some critics say that it’s easy to get new clients in this
industry. Just by issuing an unsolicited rating on a transaction, clients
seem to line up in fear of lower ratings (an industry practice called
"notching"). The rating companies put their
reputations and careers on the line with each rating; they take their
responsibilities very seriously.
These agencies were
criticized for failing to react quickly to the Enron collapse, by not
reducing their ratings faster. The truth in the matter is that Enron
collapsed so quickly that it was impossible to get a handle on the severity
of the situation. The recession in 2000 was global. Big companies all over the
world were failing. After 9/11, orders just dried up and the
economy just shut down. These agencies did the best they professionally
could, given the situation; nevertheless, Congress and the SEC are taking a
more active role in overseeing the industry.
Ratings have a big
impact on companies and their investors. The higher the rating, the lower a
company’s borrowing costs are. Another way of stating this is: the higher
the ratings, the less bond investors receive. It’s more than pure interest
costs; for the insurer, for example, bank covenants are affected and extra
collateral may be needed. If ratings are low, suppliers will demand price
concessions and faster payments. Below is an example of the complexities and
far reaching effects that these grades have.
Back in the early
1990’s, the author was a financial executive with a midsize leasing company.
The company financed its business through securitizations. One day all hell
broke loose; a large Japanese money center bank lost its triple A rating.
The leasing company’s debt rating was enhanced by letters of credit from
that Japanese bank; thus the company’s debt ratings were dependant upon the
Japanese’s bank’s rating. The securitization investors were concerned. I
don’t think they threatened to pull out, but that was one of the first
thoughts on my mind. The chief investment officer scurried around that day
to get a replacement in fast. Had securitizations dried up, the
company might not have survived. This emphasizes how integral and important
these grades are to the global financial markets.
Many financial
institutions and pension funds are prohibited from purchasing non-investment
grade securities, rated as Ba or below by Moody’s.
Following are
the main agencies and descriptions of their rating systems:
Summary of Rating Agencies
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Rating |
Moody’s |
S&P |
Fitch |
DBRS |
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Highest Investment Grade |
Aaa |
AAA |
AAA |
AAA |
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Very Strong Capacity to Pay P&I |
Aa |
AA |
AA |
AA |
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Good Capacity to Pay P&I |
A |
A |
A |
A |
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Lowest Investment Grade |
Baa |
BBB |
BBB |
BBB |
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Medium Quality |
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Speculative / Junk Bonds |
Ba |
BB |
BB |
BB |
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Modest Capacity to pay P&I |
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Greater Vulnerability to Default |
B |
B |
B |
B |
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Current Vulnerability to Default |
Caa |
CCC |
CCC |
CCC |
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Extremely Speculative |
Ca |
CC |
CC |
CC |
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In Default |
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D |
D |
D |
In the U.S., as the baby
boomers age and shift their assets more into fixed income securities, the
role of these rating agencies will only increase.
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