Conducting a thorough credit analysis can be complex requiring specialized expertise and resources.
Professional credit investors usually have these, but other investors might not.
For those looking to gauge the credit risk of an issuer without in-depth analysis, credit ratings provide a valuable tool.
A credit rating is a measurement of a borrower's credit worthiness, either in general terms or with respect to a specific debt issuance or financial obligation.
These ratings are assigned by credit rating agencies, such as Standard and Poors, s and p, Moody's and Fitch.
These agencies assess the issuer's financial health operating environment and default risk to assign a rating, helping investors to quickly understand a borrower's credit worthiness.
Importantly, these agencies are compensated by the entity seeking a rating for itself or one of its debt issues.
Here you can see the rating scales from each of these three agencies along with brief descriptions of what each rating level implies.
The ratings are divided into two main categories, investment grade or IG, and high yield, HY.
High yield bonds are sometimes referred to as non-investment grade speculative or junk bonds.
Ratings of triple B minus for S and P or Fitch B double A three for Moody's or higher are considered investment grade indicating relatively low credit risk.
Ratings of double B plus or BA one for Moodys or lower are classified as high yield reflecting higher credit risk.
But why is this investment grade versus high yield distinction important? The difference between investment grade and high yield isn't just theoretical.
It has practical implications.
Many professional investors, like fixed income fund managers, may be restricted by their investment mandates to only invest in investment grade securities.
Consequently, if an issuer is downgraded from investment grade to high yield, the pool of eligible investors shrinks significantly.
This reduction in demand can lead to a notable widening of credit spreads driven by a decrease in the bonds price, especially if the downgrade comes as a surprise.
But why is the line drawn between Triple B and double B plus? This chart helps explain this distinction by showing the Cumulative default probability over a five year period for different rating categories.
Cumulative default probability represents the likelihood that an issuer will default on its obligations within a specified timeframe.
In this case five years, we can see that the default rate remains close to zero for investment grade credit ratings, but increases significantly for high yield ratings, nearly 3% for double B rated issuers, and over 10% for single B issuers.
This steep increase in default risk illustrates the heightened credit risk associated with high yield issuers and underscores the importance of the investment grade versus high yield distinction.
Finally, it's important to understand that ratings can apply both to the issuer that's the company or government entity, and specific issues, individual bonds or debt instruments from that issuer.
An issuer rating reflects the overall credit worthiness of the borrower and is often seen as a measure of the entity's ability to meet its debt obligations in general.
An issue rating on the other hand, considers the specific terms and conditions of an individual bond, including factors like collateral, seniority, and other protections.
Consequently, an issue rating may be higher or lower than the issuer rating, depending on the security or structure of the specific debt instrument.
