Ford Baertlein D’Anna Piro Bond Ratings and Agencies

Introduction to Bond Ratings Indicator of how much default risk bonds carry One of the most important factors in bond purchases for potential investors Agencies assess and report credit worthiness of debt issues so that investors can make informed decisions Lower informational costs to investors

Bond Rating Agencies Standard and Poor’s Moody’s Investors Service Fitch IBCA The three combined rate 80% of all municipal and corporate bonds 7 rating agencies have received the Nationally Recognized Statistical Rating Organization Designation Reputation is important Purpose is to determine the credit worthiness of companies’ and governments’ debt issues Customers – corporation, governments, institutional investors, depositors, creditors, investment banks, commercial banks, and other intermediaries

History of Standard and Poor’s Henry Varnum Poor’s publication “History of Railroads and Canals in The United States” Standard’s Statistics Bureau created to provide previously unavailable financial information on U.S. companies Standard’s moved into debt ratings Standard’s added municipal bonds to debt rating services 1941 – Standard’s Statistics and Poor’s Publishing merged Today – Rate $32 Trillion of outstanding debt in 100 countries

History of Moody’s John Moody - investment entrepreneur with a talent in journalism Published “Moody’s Manual of Industrial and Miscellaneous Securities” Sold out within 2 months Company did not survive the stock market crash Moody began to offer investors analyses of securities and their investment quality ratings covered the entire U.S. bond market Survived the Great Depression because very few highly rated companies defaulted Today - serve over 100 countries, 12,000 corporations, 29,000 public finance issuers, and 96,000 structured finance obligations

History of Fitch Distant 3 rd in the industry Fitch Publishing Company was founded by John Knowles Fitch Began as a financial statistics publisher moved into ratings Today - employ 2,100 professionals in 49 offices worldwide

Industry Wide Changes 1930’s – Banks began to be assessed on quality and quantity of corporate bonds that they invested in Used to judge the safety of the bank 1936 – Regulators placed requirement that banks could not invest in bonds that received ratings lower than investment grade 1970’s – Credit Rating Agencies began charging issuers Previously investors were charged for information on the credit worthiness of debt issuers Technology boom made it easier for people to reproduce and redistribute documents Decision of the agencies (more sustainable business model) Companies and municipalities pay to have their bonds rated because investors assume the worst without information

NRSRO Nationally Recognized Statistical Rating Organization Designation 1975 – NRSRO formed SEC determined capital requirements for broker dealers for the quality of bonds they could put in their portfolios Requirements are based on bond ratings NRSRO was eventually adopted by banks, insurance companies and financial regulators Now an industry standard that bond ratings do not carry value if they are not rated by a NRSRO company No formal requirements for NRSRO designation, but the company must be cleared by the SEC S&P, Moody’s, and Fitch were grandfathered in

Ratings – Broken Down Bond ratings are an assessment of the ability of an issuer to meet its financial obligations in full and on time Ratings are a combination of computations and subjectivity Rating professionals are considered insiders Each credit rating is individualized to the entity and bond issued

Corporate Bond Ratings Credit Description Rating Company Moody’sStandard & Poor’s INVESTMENT GRADE BONDS Highest Credit RatingAaaAAA Aa1AA+ High CreditAa2AA Aa3AA- A1A+ Upper Medium CreditA2A A3A- Baa1BBB+ Lower Medium CreditBaa2BBB Baa3BBB- SPECULATIVE GRADE BONDS ( JUNK BONDS) Low CreditBa1BB+ Ba2BB Ba3BB- Very Low CreditB1B+ B2B B3B- EXTREMELY SPECULATIVE BONDS Extremely Low CreditCaa+ - Extremely SpeculativeCaCC CC Bonds in DefaultD

Bond Rating Criteria Criteria and methodology used to determine bond ratings varies by company Generally bond ratings take the following into account: Economy Debt Structure Financial Condition Demographic Factors Management Additional considerations include covenants and protections offered by bond documents

Junk Bonds Also called “speculative” and “high yield” Below BB+ or Ba1 Packaged up and included in high yield mutual funds How did they get their name?

Implications Par value, non-callable, corporate, maturity range any to 15. Bond yields and ratings have an inverse relationship The more risk, the more potential reward the investor will demand High ratings are important for companies because they imply a lower cost of borrowing Lower ratings may make bonds less liquid in the secondary market

Class Experiment Bond Non-callable, corporate bond 10 year maturity Par Value What percent return would you demand?

Class Experiment (Cont.) Now a Bond Non-callable, corporate bond 10 year maturity Par Value Rated by Moody’s as AA (investment grade, low risk of default) What percent return would you demand?

Class Experiment (Cont.) With limited information, investors are going to assume the worst If investors are assuming the worst, they are going to require a higher return This makes the cost of capital much larger for a company This is why companies opt to have their bonds rated

Criticisms of Bond Rating Agencies They do not downgrade their bonds fast enough WorldCom – issued favorable ratings 3 months before bankruptcy Enron – issued favorable ratings four days before bankruptcy Mortgage backed securities – showed few signs of insecurity before collapse Scrutinized for having too strong of relationships with corporations

Current Bonds and Ratings Recently, there has been a conflict of interest between bond raters and bond issuers because of securitization Bond raters are involved in the issuance of collateralized debt obligations by telling investment banks what needs to happen to get a certain rating Agencies make money this way Can we trust a system where raters are paid by the issuers?

Summary 3 main agencies Histories Purpose of agencies Formation of the NRSRO Ratings How they are determined Bond designations Implications Criticisms of Agencies

Questions?