Credit rating agency

A credit rating agency provides independent assessments, in the form of credit ratings, of the probability of default of companies, governments and the providers of of a wide range of financial instruments. Credit ratings have major impact on the availability and cost of credit for borrowers.

Introduction: credit ratings

The term "credit" is used in this context in its sense of trustworthiness, and refers to the extent to which its subject can be trusted to be willing and able to comply with the terms of a financial contract. Assessments of individual creditworthiness (usually stated as "credit scores") are not undertaken by organisations known as credit rating agencies, and are not further referred to in this article. Credit rating agencies assess the creditworthiness of the issuers of debt instruments, including bonds issued by corporations and governments and mortgages and their derivatives, and they express their findings as alphabetically-coded "rating" categories such as AAA, AA, and BB. Credit ratings have been presented by the issuing agencies as statements of opinion, implying the absence of any legally-enforceable commitment to their reliability.

The effects of credit ratings

Bond ratings also affect the bonds yield or the amount of return that an investor can expect on the bond. A bond which is highly rated typically has a lower yield because the issuer does not have to offer a high coupon rate in order to attract investors. This is because the high bond rating tells the investor that the company is less likely to default than most other companies. A bond which is rate lower typically has a higher yield because investors demand extra incentive to compensate for the higher risk which is involved. This extra incentive comes in the form of default risk premiums. Default risk premiums are an additional amount that borrowers must pay in order for investors to assume the higher risk. Since 1970, an average of 3.45% of speculative-grade issuers have defaulted per year, compared with just 0.05% of investment-grade issuers. Since 1983, average one year default rates rose from 0.0% for Aaa to 12.2% for B3.

Bond ratings are important because companies do default and when they do investors can lose a lot of money. There have been instances where companies have defaulted on hundreds of millions worth of bonds. AmeriServe Food Distribution Inc. defaulted on $200 million in junk bonds leaving investors with a loss of $160 million. Bond ratings are essential to the investor because they are an indicator of the default risk involved in purchasing certain bonds. With the ratings investors can make informed decisions on whether or not to purchase certain bonds.

Comparing different rating agencies Ratings S&P Moody’s Default Rate% Highest Quality AAA Aaa .52 High Quality AA Aa 1.31 Upper Medium Quality A A 2.32 Medium Grade BBB Baa 6.64 Somewhat speculative BB Ba 19.52 Low grade Speculative B B 35.76 Low grade default possible CCC Caa 54.38 Low grade partial recovery Possible CC CA 59 Default recovery unlikely C C 60

http://www.moodyskmv.com/research/whitepaper/52453.pdf go to this website. This website compare the historical yields for 5, 10 15, and 20 default rate.

Robert Brokamp (2008) “What is a Bond?”

Alex Tajirian (2007) “Cost of Borrowing & Rating Agencies”

Chris Stallman (1999) “Bond Ratings

Bill Lockyer (2007) “The Credit Rating Process” Fidelity Investments http://personal.fidelity.com/products/fixedincome/bondratings.shtml Moody’s http://www.moodyskmv.com/research/whitepaper/52453.

Ross, Westerfield, & Jordan (2008) Essentials of Corporate Finance

Works Cited List

1.Ross, Westerfield, & Jordan. (2008). Essentials of Corporate Finance (6th ed.) McGraw-Hill/Irwin

2.Chris Stallman (1999). Bond Ratings. Financial Content. http://www.teenanalyst.com/bonds/bondratings.html

3.Bill Lockyer (2007). The Credit Rating Process. Public Finance Division. http://www.treasurer.ca.gov/ratings/process.csp

4.Robert Brokamp (2008) “What is a Bond” Bond Center http://www.fool.com/bonds01.htm

5.Alex Tajirian (2007) “Cost of Borrowing & Rating Agencies” Finance Channnel http://beginnersinvest.about.com