What it means
A rating is an opinion about credit risk, expressed on a scale that runs from AAA through AA, A and BBB, then down through BB, B and the C grades to D for default. The dividing line that matters commercially sits between BBB and BB: at or above it a bond is investment grade, and below it the bond is high yield, often called junk.
That line is not cosmetic. Many pension funds, insurers and bank treasuries are restricted by their own rules to investment grade holdings, so a downgrade from BBB to BB can force a wave of selling regardless of what any individual investor thinks of the company.
The agencies are paid by the issuers whose debt they rate, which is the central criticism of the model. The defence is that ratings are published openly and an agency's whole business rests on its record, but the conflict is real and featured heavily in the 2008 financial crisis, when structured products carrying top grades defaulted.
Ratings apply to specific instruments as well as to issuers. A secured bond with first claim on assets may be rated a notch or two above the company's general rating while subordinated debt sits below it, so one company can carry several different ratings at the same time.
What a rating does not tell you is whether the bond is a good investment. It estimates the probability of not being repaid rather than the return you will earn, and a highly rated bond bought at the wrong price can still lose money when interest rates move against you.
In practice
Real-world examples.
Example
A sovereign borrower is downgraded by one notch. Its existing bonds fall in price the same day, and the government's next auction clears at a yield 0.3 percentage points higher, adding directly to the cost of servicing new debt.
Example
An insurance company's investment mandate permits only investment grade bonds. When one holding is cut from BBB to BB, the portfolio manager must sell it within ninety days under the mandate, even though he still believes the company will repay in full.
Example
A privately held retailer with no public debt seeks a rating before approaching the bond market for the first time. The process takes several months and requires detailed forecasts, and the BB rating it receives tells management that a bond issue would cost more than the bank facility it already has.
Formula
Calculation
Rating agencies do not publish a formula, but the financial effect of a rating is easy to quantify:
Annual interest cost = amount borrowed x coupon rate
Cost of a downgrade = amount borrowed x (higher coupon rate - lower coupon rate)
Worked example. A manufacturer plans to issue $50,000,000 of ten year bonds. Rated A, it expects to pay a coupon of 4.7%, giving annual interest of $50,000,000 x 0.047 = $2,350,000.
Shortly before issue, an agency cuts the rating to BBB after a debt funded acquisition, and the market now demands 5.5%. Annual interest becomes $50,000,000 x 0.055 = $2,750,000.
The downgrade therefore costs $2,750,000 less $2,350,000 = $400,000 a year, which over the ten year life of the bond is $4,000,000. The same figure comes from the spread directly, since $50,000,000 x 0.8% = $400,000, and that is why finance teams treat a rating as a hard cost line rather than a reputational score.Case study
Seen in the real world.
Corley Freight Group is an invented company used here as an illustrative example. It held a BBB rating, the lowest investment grade, and had $400,000,000 of bonds outstanding when it announced a large acquisition funded almost entirely with new debt.
Both agencies placed the rating on negative watch within a week. Corley's management, in this fictional account, had modelled the deal on its existing 4.2% cost of debt, but a fall to BB would push refinancing towards 6.5%, an extra 2.3 percentage points, or roughly $9,200,000 a year on $400,000,000 of borrowing.
The illustrative resolution was that Corley funded a quarter of the purchase price with new shares, suspended its buyback and committed publicly to a leverage target. The rating was affirmed at BBB with a negative outlook, and the finance director's summary was that the company had paid for its rating with equity because the alternative was paying for it forever in interest.
Watch out
Common mistakes.
- Reading a credit rating as investment advice, when it is an opinion on the chance of repayment and says nothing about whether the price on offer is attractive.
- Treating all investment grade bonds as equivalent, when the gap in default experience between AAA and BBB is substantial even though both sit above the dividing line.
- Assuming a rating is permanent, when outlooks, watch lists and downgrades move faster than most borrowers expect once results start to deteriorate.
Questions
People also ask.
Who actually pays the rating agencies?
In the dominant model the issuer pays for its own rating, which creates a conflict of interest that regulators monitor closely and that critics still regard as unresolved.
What is the difference between investment grade and high yield?
Investment grade covers BBB and above and is treated as suitable for conservative institutional portfolios, while high yield sits at BB and below and pays more precisely because default risk is materially higher.
Do the agencies rate anything besides bonds?
Yes, they rate sovereign governments, insurers, banks, structured products and individual loan facilities, using broadly the same scale with instrument specific adjustments.
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