The Credit Ratings of bonds are useful and simple to understand. It is a metric that tells us about the credit risk embedded in in corporate and treasury. Used with caution, credit ratings allow us to understand why the price of a bond is at a certain level.
- How are Credit Ratings Determined
- Types of Credits Ratings and their Level of Risk
- Relationship between Credit Ratings and Credit Spreads
All bonds are exposed to credit risk, whether we speak about corporate or treasury bonds. This is why credit ratings can be so useful to analyze bonds. However, credit risk can be broken down into two types of risk: default risk and credit deterioration risk.
Default risk is what almost all people think about what we speak about credit risk. It is the risk that a company or country may not be able to pay back what it borrowed. Perhaps only a fraction of that amount can be paid back. Default risk is especially important for bonds issued by entities with little creditworthiness.
Credit deterioration risk, also known as spread risk, is important for safer bonds, whose probability of default is very low. In that case, credit risk does not come directly from the fact that the company or the country may fail in the short term, but that its financial situation may deteriorate.
If the finances of a solid company begin to deteriorate, the company is unlikely to default any time soon. However, the credit quality of the bond is getting worse. That will cause the bond spread to increase, and its price to drop. Therefore, we would experience a loss even though no default has occurred or is imminent.
How are Credit Ratings Determined
Credit ratings are provided by credit rating agencies. The three most famous credit rating agencies are the American Standard & Poor’s (S&P), Moody’s and Fitch. There are also many smaller agencies, including the Canadian DBRS, but they tend to receive less attention.
These credit rating agencies are in the business of analyzing the financial statements of companies to determine their credit quality, i.e., how good of a borrower they are. Consequently, they analyze things like the total debt level, commercial margins, business growth, etc. Based on those metrics, they will estimate the level of credit risk and assign a credit rating.
For countries and regional governments, the process is similar. However, the data used will be slightly different. Along with the total debt level, indicators such as economic growth, unemployment, the level of economic activity, investments, and external trade are analyzed. In addition, the level of political stability is also taken into account.
Conflicts of Interest in the Credit Rating Business
One aspect that should not be ignored when using credit ratings to analyze potential investments is the conflicts of interest in the industry. Conflicts of interest exist because it is usually the companies and governments issuing debt which hire the services of the credit ratings agencies in order to have their debt rated.
The reason companies and governments hire credit ratings agencies is because bonds with credit ratings are more attractive to investors. Credit ratings are one of the metrics analyze by many money managers. In fact, many investments funds cannot invest in bonds unless they are rated and their credit ratings are above a certain threshold.
However, because ratings agencies are paid by borrowers, there have sometimes been problems with ratings that did not reflect reality. That is shown in the brilliant movie The Big Short and used to be more common before the 2008 financial crisis.
I make you aware of these conflicts of interest not to discourage you from using credit ratings, but so that you understand that these ratings are not infallible.
Types of Credits Ratings and their Level of Risk
While there are many different credit ratings, as seen in the table below, the big divide is between investment grade bonds and high yield bonds.
This separation is very important. Investment grade bonds are mostly exposed to credit deterioration risk, also known as spread risk. On the other hand, high yield bonds are more exposed to default risk.
Investment Grade Bonds
Investment grade bonds represent the bulk of the bond market. Many investors are willing to buy them. As you can see, despite being a very broad and heterogeneous category, they are mostly exposed to the risk of spreads increasing in the future and driving bond prices down. The percentage of bankruptcies in investment grade bonds is very low.
It is worth highlighting the importance of the worst type of investment grade bonds for financial markets. They are the ones with BBB ratings, especially in their lowest level of BBB- (or Baa3). Because ratings are continuously reviewed and updated, these bonds are exposed to the risk of falling into the high yield bond category.
This is very dangerous because, if it happens, many institutional investors will be forced to liquidate them, potentially driving their prices much lower. Bonds that have moved from investment grade to high yield are known as fallen angels.
High Yield Bonds
High yield bonds, often referred to as junk bonds, are those with the worst credit quality. They have the most default risk. There is nothing wrong investing in high yield bonds, since their spreads and potential returns tend to be higher. But they also carry a lot more risk.
Within the junk bond category, not all bonds are equally risky. Those with BB ratings experience relatively few bankruptcies. On the other hand, bonds with CCC ratings and lower can declare bankruptcy at any time.
Junk bonds offer the potential for greater returns and losses. For this reason, if there is a boom in the economy, junk bonds tend to rise a lot in price and there are few bankruptcies, proving to be a very strong investment. At the same time, if the economy falls into a recession, bankruptcies will go up, credit spreads will rise and high yield bond investors will suffer significant losses .
Regardless of the type of bonds you would like to invest in, doing it through mutual funds and ETFs tend to be the best option. These funds have better liquidity than most individual bonds and do not require you to be aware of specific companies or countries.
Relationship between Credit Ratings and Credit Spreads
As you can imagine, there is a clear relationship between a bond’s credit rating and its credit spread. The credit rating indicates its level of credit risk according to the credit ratings agencies. The credit spread tells us the level of risk according to the market.
For this reason, credit rating and credit spread are two metrics that are usually strongly correlated. The following table shows the average credit spread for credit rating category on dollar-denominated bonds:
As you can see, as the credit rating moves down in the quality spectrum, credit spreads increase at an exponential rate. This is because, as we go down in quality, the probability of bankruptcy increases much faster.
When the market (credit spread) and the ratings agencies (credit rating) have different opinions, the logical thing is to trust the market. There are several reasons for that, but in most of those situations, credit ratings agencies are slow to update their ratings. For its part, the market moves immediately if important news comes out.
Relationship between Ratings, Spreads and Dividends
Even if you do not invest in bonds, paying attention to credit ratings and credit spreads is important. This is especially true if we invest in dividend-paying stocks. This is because many of these companies also have significant levels of debt.
Monitoring the quality of a company’s debt can allow us to assess if the dividends it pays are sustainable or may be at risk in the future.
For example, if we see that most of our dividend-paying companies are in the lowest categories of investment grade debt (BBB), there is a risk that the dividends of some of them will be cut in the near future. That becomes more likely if a company has the misfortune to see its credit rating downgraded to BB (high yield). After all, debt payment must be serviced before any dividend payments can be considered.
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