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Cost of Borrowing & Rating Agencies

 One of Wall Street’s major credit-rating agencies, Moody’s Investors Services Inc., is being investigated by the U.S. Justice Department for alleged antitrust violations, according to the Journal (3/27/96, p. C1).

 The investigation centers around whether Moody’s pressured bond issuers to either use its services to evaluate their debt or face negative comments and lower ratings.

Bond Ratings. Credit worthiness is rated by credit-rating agencies dominated by two giants, Moody’s and Standard & Poor’s, with a distant third, Fitch Investors Service. In effect, these companies rank others based on their chances of defaulting. Note that default does not necessarily mean failing to pay the full interest on the debt, but rather the potential for delays in payment. Once again, I am trying to stress that in valuing assets not only the amount and risk of cash-flows are important, but their timing -when you actually receive the promised cash flows - play a major role in determining their value.

The highest quality rating is AAA, followed by AA, and so on. Rating below BBB is referred to as non-investment quality or junk bonds, where non-investment means that certain institutional investors are not allowed by law to invest in these bonds.

Note that U.S. government bonds are not rated as they are considered default free. Moreover, these agencies rate debt issued by corporations as well as munis - those issued by states, counties and municipalities.

 

Q So why should companies care about how their credit is rated?

A There are two disadvantages of lowered ratings:

(1) The lower the rating, the higher the cost of borrowing. Thus, the lower the company’s value.

(2) The lowering of rating might make the bonds less liquid in the secondary market. This would also increase the bond’s YTM (i.e., the required return on the bonds), thus increasing the cost of borrowing for the firm.

 

Q Should individuals who have no intention of buying any of these companies’ bonds care about the ratings?

A

Yes in a number of situations. Would you open a savings account with a bank whose bonds have a very high chance of default, say junk bonds? Would you buy a life insurance policy from a company that does not have a high quality bond rating? Obviously not.

Conversely, that is why banks and insurance companies try to maintain a high quality rating, otherwise they would have a tough time competing for customers.

BOND RATINGS

Rating Agency

   
Moody's Standard & Poor's Investment Quality Description
Aaa AAA Highest grade Very strong capacity to pay interest and principal.
Aa AA High grade Strong capacity to pay
A A Medium Quality Bond is more susceptible to adverse changes.
Baa BBB    
Ba, B

Ca, C

BB,B

CC, C

Low Quality

Speculative

"Junk bonds"

Highly speculative in their ability to meet interest and principal obligations
D D In default Interest and/or repayment are in arrears.

 

Note. At times, both agencies use adjustments. S&P uses "+" or "-" to indicated strength or weakness, Moody's uses 1, 2, or 3, with 1 being the highest.

 

By Alex Tajirian


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