Bond Rating and Agencies

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Bond Rating and Agencies. Wen-Hao Lo 5/4/2011. Bond rating features. Assessment Information asymmetries between borrowers and lenders Ratings indicate the likelihood of the borrowed money being paid back Each agency has it own rating scale (independent assessment) Efficiency - PowerPoint PPT Presentation

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Bond Rating and Agencies

Bond Rating and AgenciesWen-Hao Lo

5/4/2011

1Bond rating featuresAssessment Information asymmetries between borrowers and lenders Ratings indicate the likelihood of the borrowed money being paid backEach agency has it own rating scale (independent assessment)

EfficiencyCostly and duplicative for purchasers to do their own researchRapid dissemination of informationRatings compare relative risks of different debt issuesRatings scale is a consistent framework for comparisons

2Bond rating featuresDuration Last until the bond expiresChanges if there is an upgrade/downgrade in the ratings over time

MethodsQuantitative analysis: ratio analysis, economic outlook, industry analysis, company trendsQualitative analysis:management team, policy, business outlook

3Rating processSource: Standard & Poors Corporation, S&Ps Corporate Finance Criteria (New York: Standard & Poors Corp, 1922), p.9.4Bond rating industryInvestor pays Model1931: rating incorporated into regulation The U.S. Office of the Comptroller of the Currency (OCC) rules1936: banks prohibited from investing in below-investment-grade bonds (the force of law)1959: Xerox (game changer)1975: SEC created NRSRO category (barrier to entry) A Nationally Recognized Statistical Rating Organization (NRSRO) is a credit rating agency which issues credit rating the SEC permits other financial firms to use for certain regulatory purposes.Early 1970s: industry switched to Issuer Pays Model

OCC US Office of the Comptroller of the Currency5Major playersThree primary agencies: Moodys Investors Service, Standard & Poors (S&P) Rating Services, Fitch IBCA Inc.

6Moodys Founded in 1909 by John Moody Analyses of Railroad Investments,, using letter grades to assess their risk. 1914: Moody's Investors Service was incorporated.1924: Moody's ratings covered nearly 100 percent of the US bond market.1970s: Moody's expanded into commercial debt.Announcements by Moody's of downgrades of a country's bond rating can have a major political and economic impact.

7Standard and Poor (S&P)

1860: Henry Poor first published the History of Railroads and Canals in the United States.1906: Luther Blake founded the Standard Statistics Bureau, with the view to providing financial information on non-railroad companies.Subsequent entry into the rating business: Poors (1916); Standard (1922)1941: Poor and Standard Statistics merged to become Standard & Poor's Corp. 1966: S&P was acquired by the McGraw-Hill Companies, and now encompasses the Financial Services division.Standard and Poor's has become best known by indexes (S&P 500)8Fitch1913: Founded by John Fitch1924: Introduced first letter scale from 'AAA' to 'D (later adopted and licensed by S&P)1997: Fitch merged with London-based IBCA. 2004, Fitch developed operating subsidiaries specializing in enterprise risk management.Fitch Ratings is the smallest of the "big three" NRSROs, covering a more limited share of the market than S&P and Moody's.

9Bond Rating Grades (short-term)Credit RiskMoody'sS&PFitch best quality grade (exceptionally strong) P-1A-1+F-1+ best quality grade (strong) A-1F-1 good quality gradeP-2A-2F-2 fair quality grade P-3A-3F-3 speculative natureNot PrimeBB possibility of default is highCC the obligor is in defaultDD 10Bond Rating Grades (long-term)Credit RiskMoody'sS&PFitch Investment GradeHighest QualityAaaAAAAAAHigh QualityAa1, Aa2, Aa3AA+, AA, AA-AA+, AA, AA-Upper MediumA1, A2, A3A+, A, A-A+, A, A-MediumBaa1, Baa2, Baa3BBB+, BBB, BBB-BBB+, BBB, BBB-Not Investment GradeSpeculativeBa1BB+BB+Speculative MediumBa2, Ba3BB, BB-BB, BB-Speculative Lower GradeB1, B2, B3B+, B, B-B+, B, B-Speculative Risky Caa1CCC+CCCSpeculative Poor StandingCaa2, Caa3CCC, CCC---No Payments / BankruptcyCa / C----In Default--DDDD, DD, D11

12 There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moodys can destroy you by downgrading your bonds. And believe me, its not clear sometimes whos more powerful.

Thomas L. Friedman, PBS News Hours Feb. 13, 1996

However, a rating is notThe issue credit rating is not a recommendation to purchase, sell, or hold a financial obligation, in as much as it does not comment as to market price or suitability for a particular investor.

13Agency problemRating preferenceMoodys rate slightly more negatively on average than S&PMoodys is more likely than S&P to be the first agency to initiate a rating change, S&P is arguably more aggressive about their ratings.Moodys is more negative rater for small issue and issuer, and for more highly levered firms. Split rating: S&P 94; Moodys 36 14Rating Agency Perspective Upgrades versus DowngradesS&P reported more upgrades than downgrades in 2010 the first time this occurred since 2006.The downgrades convey bad news to holders, but upgrades are less informative

15Agency problemConflict of interest: Bond rating agencies earn revenues from fees paid by bond issuers.

Rating shopping: High fee groups get better bond rating than Low fee groups.

Free rating: Rating agencies offer free service. Jefferson County, Colorado School District: general obligation bonds (Oct, 1992) Moodys : A2 Rating Fee VS. 1st Amendment

16DiscussionIf you were a bond issuer, would you join the rating or not? Why?

If you were an investor, how would you interpret the rating? Why?

17In terms of S&P rating, which one is in the investment level?

a. BBB-

b. Baa3

c. BB+

18In terms of Moodys rating, which one is in the speculative level?

a. BB-

b. Baa3

c. Ba1

19Source (S&P):http://www.standardandpoors.com(Moodys):http://www.moodys.com(Fitch IBCA):http://www.fitchibca.com(SEC): http://www.sec.gov http://www2.standardandpoors.com/spf/html/media/SP_TimeLine_2006.html. Retrieved April 25, 2011.Standard & Poors Corporation, S&Ps Corporate Finance Criteria (New York: Standard & Poors Corp, 1922), p.9.Timothy J. Sinclair, The New Masters of Capital (New York: Cornell University Press, 2005)20Thank you!

Questions?

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