The Finance Tutor

Return to Homepage

Credit Risk: Comprehensive Analysis

Credit Risk is the risk that the issuer of a bond could experience financial strains and become unable to make interest and/or principal payments. If an issuer defaults on its debt service requirements, the value of its existing bonds will deteriorate significantly.

Independent credit rating agencies such as Moody's and Standard & Poor's monitor the financial soundness of many companies and municipalities and publish ratings that reflect their financial conditions. The company-specific factors that are considered when rating an issuer’s debt service capacity include: sustained profitability, growth prospects, short and long-term liquidity, overall leverage, and sustained competitive advantage. External factors include industry performance, macroeconomic conditions, etc.

Corporations and municipal bond issuers strive to maintain high credit ratings. If a credit rating agency upgrades the outlook of an issuer, the yield the issuer must offer to borrow capital will decline, and the prices of its outstanding bonds should increase.

The following chart details the rating classifications of three major rating agencies:

Long-Term Bond Rating Classifications
Moody’s	S&P’s	Fitch	Definition
Aaa	AAA	AAA	Best quality. Indicates a very strong debt service capacity. Minimal degree of investment risk. Considered highest grade.
Aa	AA	AA	High quality. Considered high-grade.
A	A	A	Possess favorable qualities. However, may be susceptible to adverse economic changes.
Baa	BBB	BBB	Neither highly protected nor poorly secured. Has adequate capacity to cover debt service requirements.
Ba	BB	BB	Possess questionable attributes. Considered speculative.
B	B	B	Generally lacks characteristics of a desirable investment. Little assurance of credit capacity over the long term.
Caa	CCC	CCC	Bonds of poor standing. May be in default.
Ca	CC	CC	Little prospect of ever attaining a reasonable investment standing. May be in default.
-	D	DDD	Issues in default with principal or interest payments in arrears. Such bonds are often valued on the basis of liquidation or reorganization.
Sources: Moody’s, Standard & Poor’s, and Fitch.

Investment Grade/Non-Investment Grade

Rated bonds fall into two classifications: investment grade and high-yield. Bonds rated Baa/BBB or above are considered investment grade. Bonds rated Ba/BB or below are considered high-yield. The distinction was originally made because commercial banks, historically, were only allowed to invest in investment grade debt. Today many funds limit their holdings to investment grade debt.

Questions:

What are the company-specific attributes and external factors analyzed when assigning a credit rating to an issuer?
Why do bond issuers strive to maintain exemplary credit ratings?
Distinguish between investment grade and high-yield debt.

Answers:

-Reference-