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Bonds

 - Type of Yields

 - Bond Rating Agencies

 - The Yield Curve

 - Laddering

Types of Bonds
 - Corporate Bonds

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Bond Rating Agencies

Bond rating agencies review a company’s credit worthiness to determine if a company can repay its debts in a timely fashion. They then grade the company. The rating system is clearly explained and the agencies try to make the reasons behind the rating decisions as transparent as possible. Normally, the CFO of an organization coordinates with the rating agencies, to supply all proper documents and to answer the boiler plate questions. The rating agency meets with the management, clients, bankers, and suppliers, to properly grade the company. Yes, there is some “wheeling and dealing” involved, but at the end of the day, these agencies are extremely diligent and will not jeopardize their reputation and business, for a few dollars. They also have other sources of revenues, like subscription based services, so most clients are not material. Some critics say that it’s easy to get new clients in this industry. Just by issuing an unsolicited rating on a transaction, clients seem to line up in fear of lower ratings (an industry practice called "notching"). The rating companies put their reputations and careers on the line with each rating; they take their responsibilities very seriously.

These agencies were criticized for failing to react quickly to the Enron collapse, by not reducing their ratings faster. The truth in the matter is that Enron collapsed so quickly that it was impossible to get a handle on the severity of the situation. The recession in 2000 was global. Big companies all over the world were failing. After 9/11, orders just dried up and the economy just shut down. These agencies did the best they professionally could, given the situation; nevertheless, Congress and the SEC are taking a more active role in overseeing the industry.

Ratings have a big impact on companies and their investors. The higher the rating, the lower a company’s borrowing costs are. Another way of stating this is: the higher the ratings, the less bond investors receive. It’s more than pure interest costs; for the insurer, for example, bank covenants are affected and extra collateral may be needed. If ratings are low, suppliers will demand price concessions and faster payments. Below is an example of the complexities and far reaching effects that these grades have.

Back in the early 1990’s, the author was a financial executive with a midsize leasing company. The company financed its business through securitizations. One day all hell broke loose; a large Japanese money center bank lost its triple A rating. The leasing company’s debt rating was enhanced by letters of credit from that Japanese bank; thus the company’s debt ratings were dependant upon the Japanese’s bank’s rating. The securitization investors were concerned. I don’t think they threatened to pull out, but that was one of the first thoughts on my mind. The chief investment officer scurried around that day to get a replacement in fast. Had securitizations dried up, the company might not have survived. This emphasizes how integral and important these grades are to the global financial markets.

Many financial institutions and pension funds are prohibited from purchasing non-investment grade securities, rated as Ba or below by Moody’s.

Following are the main agencies and descriptions of their rating systems:

Summary of Rating Agencies

Rating Moody’s S&P    Fitch DBRS
Highest Investment Grade Aaa AAA AAA AAA
Very Strong Capacity to Pay P&I Aa AA AA AA
Good Capacity to Pay P&I A A A A
Lowest Investment Grade Baa BBB BBB BBB
Medium Quality
Speculative / Junk Bonds Ba BB BB BB
Modest Capacity to pay P&I
Greater Vulnerability to Default B B B B
Current Vulnerability to Default Caa CCC CCC CCC
Extremely Speculative Ca CC CC CC
In Default   D D D

In the U.S., as the baby boomers age and shift their assets more into fixed income securities, the role of these rating agencies will only increase.

 

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