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LESSON SUMMARY
As a bond investor, you are not only looking at the potential return you can get in terms of the coupon rate. The return is also heavily determined by the risk of the company defaulting, in which you don’t get any future payments. This lesson will tell you about the credit rating agencies that can assist you in the process. The lesson also includes the following points:
1) Who are the major credit rating businesses agencies: Standard & Poor, Moody’s, and Fitch are called the “Big Three”. When investors look at the quality of debt for companies, the easiest way is to look up the credit rating from one of the big agencies and use that as an indicator.
2) What characterizes a good credit rating: The Big Three has somewhat of the same system when they rate company bonds. The notation is slightly different but if you see something called “Aaa” or “AAA” it’s a strong indicator that the risk of the company to default is very slim.
LESSON TRANSCRIPT
UNDERSTANDING CREDIT RATINGS
There are three different major credit companies – Moody’s, S&P, and Fitch. They basically have the exact same rating scheme. Moody has an Aaa, whereas S&P uses AAA. It’s all the same thing; it’s all the same scale.
As you look at the scale in the video, you can see the top has a prime investment. Meaning, it doesn’t get any better. This is a company that can absolutely repay its debts. At the very bottom, as you look down, the lowest is in default. Stay away from that, because that company or government institution is about to go bankrupt; they won’t be able to repay their loans.
When buying a bond, an AAA or Aaa bond has the chance of repaying all coupons and giving the Par value back at the end of the investment. This is very good with the prime investment. The one rated in default is very bad. They most likely cannot pay. Everything in between is something to figure out.
Still basing on the video, as you go down the scale, there’s investment rate and there’s noninvestment rate. Everything above the BBB- or the Baa is considered investment rate, anything below that is noninvestment and understood as being speculative. That’s important to understand. This can work for both bonds and stocks.
When buying stocks and concerned about whether a company has debt, go to the corporate page, find the information, check the debts, and look at their bonds. You’ll see what the category is for those bonds that the company has. When the company has a bunch of AAA bonds, in no circumstance will they be in trouble to repay debts, and that’s a good thing. It is important to buy stocks at companies with little or no debt. If they have, they need to have a very high credit rating.
When buying bonds, you can bargain with coming a little bit lower, but that’s all based on the amount of risk that you’re willing to assume.
The meaning of an AA bond is frustrating. How much risk is that? There’s no way to answer without knowing the numbers associated with the rating. The charts don’t tell anybody anything, because there are no statistics behind them. Here are statistics behind it to show what some of these ratings are equal to.
Only Moody and S&P numbers are here. Look at the chart and see the comparison. How many numbers are in default? At the very top of both Moody and S&P, if you had that rating, there’s a 0% chance that you’re going into default. If you’re a corporation, you can see for Moody it was .52% and for S&P it was .60%; that‘s how much the risk is. You could see at a number how much risk-associated the ratings for both of these are.
Remember, the BA or BB bond is whenever things start becoming speculative in the noninvestment rate. Look at those numbers and see a drastic change in the number. Something interesting is the corporation number for the BB for Moody. 19.12% of those companies went into default. 20% is really high. When you look at the S&P, they almost had 30%, so S&P has a much higher rating compared to Moody. When you look lower, you can see how much higher those numbers go. When you look into the category especially for corporations, 70% for both Moody and S&P is extremely high. When buying bonds that are down there, there’s only about a 30% chance you’ll get your money back, which really low.
It’s nice to know the numbers behind these letters, which absolutely have no meaning to anybody for a person who is involved with buying and selling bonds. When you look down there at the numbers for the average, if you’re buying investment rates for corporations with Moody’s rating, there’s only a 2% chance of failing. For S&P, it’s 4%, which is very significant when you look at how their rating stands.
For non-investment grade, the numbers go much higher, especially for corporations. People will look at an AAA rating for a corporation, but that’s almost the same as getting down there in a BBB. When you are comfortable buying an AAA corporate bond, you should be equally comfortable buying a BBB bond, because the numbers are better than the AAA corporate.
When buying bonds, think about the charts and how secure they are as we go into a lower category and rating.
Cumulative Historical Default Rate
| Moody’s | Moody’s | S&P | S&P | |
| Rating Category | Muni | Corp | Muni | Corp |
| Aaa/AAA | 0.00% | 0.52% | 0.00% | 0.60% |
| Aa/AA | 0.06% | 0.52% | 0.00% | 1.50% |
| A/A | 0.03% | 1.29% | 0.23% | 2.91% |
| Baa/BBB | 0.13% | 4.64% | 0.32% | 10.29% |
| Baa/BB | 2.65% | 19.12% | 1.74% | 29.93% |
| B/B | 11.86% | 43.34% | 8.48% | 53.72% |
| Caa/CCC | 16.58% | 69.18% | 44.81% | 69.19% |
| – | ||||
| Averages | ||||
| Investment Grade | 0.07% | 2.09% | 0.20% | 4.14% |
| Non-Investment Grade | 4.29% | 31.27% | 7.37% | 42.35% |
WHAT’S IMPORTANT?
- A public opinion poll is no substation for thought. – Warren Buffett
- Looking at the letters is pointless. You need to understand the statistics behind the letters. – This gives you a metric for risk.
- In the end, measure your own tolerance risk and be realistic in what you actually know.
In this lesson, students learned how to read a credit rating score. The most important aspect of reading a credit report is understanding what the letters represent. As we initially looked at the chart, the letters had no meaning. Once we put statistical information to the chart, intelligent investors can then assess the amount of risk associated with their decisions.
One of the key points we learned in this lesson is the difference between municipal bonds and corporate bonds. Although these two securities may have the same credit score, their chance of default is drastically different. For a corporate bond, defaults are much more prevalent compared to municipals. This is something to definitely understand and compare when you begin shopping for great bond picks.
LESSON VOCABULARY
Credit Rating Agencies
Examples include Moody’s, S&P, and Fitch. These credit agencies rate the safety of bonds, thereby giving investors a second opinion of the risk of the company not being able to meet debt obligations.
