Credit rating agency and Bond Rating
What is a rating agency?
Well these credit rating agencies are exactly what they sound like they evaluate the ability of companies to be able to pay back their debtors by making timely interest payments and the likelihood of a company’s default risk. This would be similar to your credit scores. They are in effect the same thing but different measures for companies’ vs individuals. Currently there are only three credit rating agencies in America each with large portions of the market. Moody’s Investors Service and Standard and Poor’s both control about 80% of the global market while Fitch Ratings control 15% of the market. These rating agencies came about as America began to move and expand westward. As businesses were no longer located near lenders, America needed a new way to evaluate a debtor’s ability to pay them back. That’s when the credit agency was born.
What are they based upon?
So now that we know who the “big three” are and where they came from. We can move onto what are the ratings based upon. The ratings are based upon a percent weighting for each aspect of the business. Here is Moody’s chart weighting scale: (I’ll be focusing on only Moody’s rating company)
Scale:
So we can see how they are rated but many people might not know what these things are so I’ll give a brief description of what each is. Scale takes Revenue and Total or fixed assets for a total 20% weighting.
Revenue is the amount of money a business actually receives during a given period of time.
While total assets equal to liabilities plus stockholder’s equity. Assets are defined as anything that a business owns, which has value and can be turned into cash.
Business profile:
A business profile is a kind of a summary of what a company does. It’s a set of data portraying significant features of the corporation in question. Most of these profiles/summaries contain data like yearly estimated revenue, number of employees, business purpose. And the Moody rating agency gives this a 30% weighting.
Leverage:
Debt:
Obviously the amount of money a company owes to the bank or other creditors.
Net debt:
Net debt shows a business’s overall financial situation. The formula is
short term debt +long term debt- cash and highly liquid assets (could be like company owned stocks).
This is used as an indicator of a business’s ability to pay off all of its debts. If they all became due on the same day net debt would tell you if you had enough cash and liquid assets to cover it all. This is a fairly good indicator of financial health.
Funds from operations:
It’s a figure business’ use to define the cash flow from their operations. This takes into account net income, depreciation of assets, and payments of debts. Many business’ own real estate or other capital that need depreciation taken into account.
Financial policy:
Financial policy is a lot like a business profile, here they describe a corporation’s choices for its debt/equity mix, which currencies a company chooses to keep its cash in, methods of financing future projects, and so forth.
That about sums up how Moody’s chooses to rate things and what holds more weight in their determination of credit rating. So now that we have a basic understanding of how they are weighted we will move onto what the ratings are.
What is triple A or aa2?
So as we know that a credit rating agency evaluate the strength of a business, we know what weights are given for each section of the business and we know a little about each section. Now let’s move on to the actual rating Moody gives out. I pulled some data from a study done by Moody’s company in 2008 over the corporate default and recovery rates/risk. The rating’s go in order from Best to worse:
So obviously we see here that the best is Triple A(Aaa) then followed by double A(Aa or aa2) and so forth… all the way down to speculative-grade. So this table might look strange and confusing but I’ll try to explain it the best I can.
The numbers shown here are percentages. So let’s take year 5 B level rating; over a period of five years with a portfolio of B-rated companies, on average, 25.02% of them will have defaulted. The same can be said for Caa but with 45.8%. If you’re on the more conservative side when it comes to investing, it’s best to stay with the higher rated companies just to be safe. Now obviously if a company defaults on a loan it’s not the end of the world. But it can result in them being sued to get the money or seizure of assets. Overall, it’s good for a company to be able to payback their loans.
Conclusion:
We’ve learned about what a credit rating agency is and the ratings they give to companies.
If you’d like to learn more there are two books on amazon that I found which talk about credit rating agencies. Personally, I’d go with “The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness (Cornell Studies in Political Economy)
Disclaimer and Author’s Bio:
Kendon started TheCryptoDivision in 2017 in order to help people understand cryptocurrency and learn about the unique opportunities in the space. Kendon is an economics graduate from BYU. He is working for an investment bank in the foreign exchange department.
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