Bond Rating and Agencies Wen-Hao Lo 5/4/2011

Bond rating features Assessment Information asymmetries between borrowers and lenders Ratings indicate the likelihood of the borrowed money being paid back Each agency has it own rating scale (independent assessment) Efficiency Costly and duplicative for purchasers to do their own research Rapid dissemination of information Ratings compare relative risks of different debt issues Ratings scale is a consistent framework for comparisons

Bond rating features Duration Last until the bond expires Changes if there is an upgrade/downgrade in the ratings over time Methods Quantitative analysis: ratio analysis, economic outlook, industry analysis, company trends Qualitative analysis: management team, policy, business outlook

Rating process Request rating Assign analytical team Conduct basic research Meet issuer Rating committee meeting Appeals process Issue ratingSurveillance Source: Standard & Poor’s Corporation, S&P’s Corporate Finance Criteria (New York: Standard & Poor’s Corp, 1922), p.9.

Bond rating industry “Investor pays” Model 1931: rating incorporated into regulation The U.S. Office of the Comptroller of the Currency (OCC) rules 1936: banks prohibited from investing in below-investment- grade bonds (the force of law) 1959: Xerox (game changer) 1975: SEC created NRSRO category (barrier to entry) A Nationally Recognized Statistical Rating Organization (NRSRO) is a credit rating agency which issues credit rating the SEC permits other financial firms to use for certain regulatory purposes. Early 1970s: industry switched to “Issuer Pays” Model

Major players Three primary agencies: Moody’s Investors Service, Standard & Poor’s (S&P) Rating Services, Fitch IBCA Inc.

Moody’s Founded in 1909 by John Moody Analyses of Railroad Investments,, using letter grades to assess their risk. 1914: Moody's Investors Service was incorporated. 1924: Moody's ratings covered nearly 100 percent of the US bond market. 1970s: Moody's expanded into commercial debt. Announcements by Moody's of downgrades of a country's bond rating can have a major political and economic impact.

Standard and Poor (S&P) 1860: Henry Poor first published the History of Railroads and Canals in the United States. 1906: Luther Blake founded the Standard Statistics Bureau, with the view to providing financial information on non-railroad companies. Subsequent entry into the rating business: Poor’s (1916); Standard (1922) 1941: Poor and Standard Statistics merged to become Standard & Poor's Corp. 1966: S&P was acquired by the McGraw-Hill Companies, and now encompasses the Financial Services division. Standard and Poor's has become best known by indexes (S&P 500)

Fitch 1913: Founded by John Fitch 1924: Introduced first letter scale from 'AAA' to 'D‘ (later adopted and licensed by S&P) 1997: Fitch merged with London-based IBCA. 2004, Fitch developed operating subsidiaries specializing in enterprise risk management. Fitch Ratings is the smallest of the "big three" NRSROs, covering a more limited share of the market than S&P and Moody's.

Bond Rating Grades (short-term) Credit RiskMoody'sS&PFitch best quality grade (exceptionally strong) P-1 A-1+F-1+ best quality grade (strong)A-1F-1 good quality gradeP-2A-2F-2 fair quality gradeP-3A-3F-3 speculative natureNot PrimeBB possibility of default is high CC the obligor is in default DD

Bond Rating Grades (long-term) Credit RiskMoody'sS&PFitch Investment Grade Highest Quality AaaAAA High QualityAa1, Aa2, Aa3AA+, AA, AA- Upper MediumA1, A2, A3A+, A, A- MediumBaa1, Baa2, Baa3BBB+, BBB, BBB- Not Investment Grade Speculative Ba1BB+ Speculative MediumBa2, Ba3BB, BB- Speculative Lower GradeB1, B2, B3B+, B, B- Speculative RiskyCaa1CCC+CCC Speculative Poor Standing Caa2, Caa3CCC, CCC--- No Payments / Bankruptcy Ca / C-- In Default--DDDD, DD, D

“ There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.” Thomas L. Friedman, PBS “News Hours” Feb. 13, 1996

Agency problem Rating preference Moody’s rate slightly more negatively on average than S&P Moody’s is more likely than S&P to be the first agency to initiate a rating change, S&P is arguably more aggressive about their ratings. Moody’s is more negative rater for small issue and issuer, and for more highly levered firms. Split rating: S&P 94; Moody’s 36

Rating Agency Perspective Upgrades versus Downgrades S&P reported more upgrades than downgrades in 2010 – the first time this occurred since The downgrades convey bad news to holders, but upgrades are less informative

Agency problem Conflict of interest: Bond rating agencies earn revenues from fees paid by bond issuers. Rating shopping: High fee groups get better bond rating than Low fee groups. Rating shopping Free rating: Rating agencies offer free service. Jefferson County, Colorado School District: general obligation bonds (Oct, 1992) Moody’s : A2 Rating Fee VS. 1 st Amendment

Discussion If you were a bond issuer, would you join the rating or not? Why? If you were an investor, how would you interpret the rating? Why?

In terms of S&P rating, which one is in the investment level? a. BBB- b. Baa3 c. BB+

In terms of Moody’s rating, which one is in the speculative level? a. BB- b. Baa3 c. Ba1

Source (S&P): (Moody’s): (Fitch IBCA): (SEC): TimeLine_2006.html. Retrieved April 25, TimeLine_2006.html Standard & Poor’s Corporation, S&P’s Corporate Finance Criteria (New York: Standard & Poor’s Corp, 1922), p.9. Timothy J. Sinclair, The New Masters of Capital (New York: Cornell University Press, 2005)

Thank you! Questions?