CapMar Lec4

IM Lesson 4 Credit Ratings affecting Bond Market

Credit Ratings

• assessments of creditworthiness of issuers of debt (corporations, municipalities, governments) & debt instruments they issue

• provides a measure of credit risk associated with various debt instruments

• these ratings help investors make informed decisions & play a crucial role in determining borrowing costs for issuers

• these ratings indicate the likelihood that the issuer will be able to meet its debt obligations (interest payments & principal repayment)

According to Corporate Finance Institute (CFI), a credit rating is?

an opinion of a particular credit agency regarding the ability & willingness an entity (government, business, individual) to fulfill its financial obligations in completeness & within the established due dates

Type of Credit Ratings

1. Investment Grade

2. Speculative-Grade or Junk

Investment Grade Ratings

• low to moderate risk of default

• ratings are typically categorized as

  • AAA: Highest credit quality

  • AA, A, BBB: Lower grades within investment-grade categories

Speculative-Grade or Junk Ratings

• higher risk of default

• ratings are typically categorized as

  • BB, B, CCC, CC, C, D: increasingly speculative & higher risk

Major Credit Rating Agencies

• responsible for assigning credit ratings to issuers & their debt instruments

• each uses its own methodologies & criteria to assess credit risk, but all consider similar factors including financial stability, economic environment, & issuer-specific conditions

1. Standard & Poor’s (S&P)

2. Moody’s Investors Services

3. Fitch Ratings

Standard & Poor’s (S&P)

one of the most prominent credit rating agencies, known for its broad range of ratings & indices

Moody’s Investors Service

provides credit ratings & research on debt instruments & issuers

Fitch Ratings

offers ratings & analysis across a wide array of financial instruments

Significance of Credit Ratings

1. Impact on Issuers

2. Impact on Investors

Impact on Issuers

• Cost of Borrowing

  • higher credit ratings generally lead to lower borrowing costs for issuers

  • lower-rated issuers typically face higher interest rates to compensate for increased risk

• Access to Capital

  • investment-grade ratings allow issuers to access a broader range of investors, including those restricted to investment-grade assets

Impact on Investors

• Risk Assessment

  • ratings provide a standardized measure of credit risk, helping investors assess the risk associated with specific debt instruments

• Portfolio Management

  • investors use credit ratings to diversify portfolios & align investments with their risk tolerance

How Credit Ratings are Determined

1. Financial Analysis

2. Economic & Industry Analysis

3. Qualitative Factors

Financial Analysis

1. Financial Statements - agencies analyze financial statements (balance sheets, income statements, cash flow statements)

2. Financial Ratios - key ratios are evaluated (debt-to-equity, interest coverage, liquidity ratios)

Economic & Industry Analysis

1. Economic Conditions - broader economic conditions & trends are considered

2. Industry Conditions - health & prospects of the industry in which the issuer operates are assessed

Qualitative Factors

1. Management Quality - track record & expertise of the issuer’s management team are considered

2. Operational Risks - operational challenges & business risks are evaluated 

Limitations & Criticisms

• credit ratings play crucial role by providing a standardized measure of credit risk

• they offer valuable insights for investors & issuers, but need to understand their limitation & factors influencing ratings for informed decision-making

  • Potential Conflicts of Interest

  • Lagging Indicators

  • Impact of Rating Changes 

Potential Conflicts of Interest

Issuer Pays Model: agencies are paid by issuers for ratings, which may lead to conflicts of interest & potential biases

Lagging Indicators

Historical Data: ratings may be based on historical data & may not be always reflect current conditions or future risks

Impact of Rating Changes

Market Reactions:  changes in ratings can lead to significant market reactions, affecting bond prices & investor sentiments

Enron Scandal of 2001 & its Credit Ratings

Enron Corporation

• american energy, commodities, & services company

• based in Houston, Texas

• infamous for one of the largest corporate frauds 

• founded in 1985 by Kenneth Lay

• rapidly grew to become a major player in the energy sector & was renowned for its innovative trading strategies & aggressive business expansion

• one of the largest companies in US with reported revenues of over $100 billion in 2000 

Enron Scandal

• their spectacular rise was fueled by fraudulent accounting practices designed to hide the company’s true financial condition

• used complex financial structures, including special purpose entities (SPEs) to keep large amounts of debt off its balance sheet & inflate its earnings

• executives (CEO Jeffrey Skilling & CFO Andrew Fastow) manipulated financial statements to present a misleadingly strong performance, which misled investors, regulators, & the public

• scandal began to unravel in October 2001 when Enron announced a massive third-quarter loss & a significant reduction in shareholder equity due to hidden debts

• disclosure led to a loss of investor confidence & rapid decline in the company’s stock price

• filed for bankruptcy on December 2, 2001 which was the largest bankruptcy in US history at the time, resulting in the loss of thousands of jobs & billions of dollars investments

Credit Ratings of Enron After the Scandal Emerged

• credit rating agencies responded by downgrading Enron’s multiple times in a short period

• November 28, 2001: S&P, Moody’s, & Fitch downgraded Enron’s credit rating to junk status (non-investment grade)

  • S&P: downgraded Enron to BB+, below the investment-grade threshold, considered speculative & indicates a higher risk of default

  • Moody’s: downgraded Enron to Ba1, a non-investment grade, indicating substantial credit risk

  • Fitch: downgraded Enron to BB+

•  November 29, 2001: S&P downgraded Enron again to B-

• December 2001: before Enron’s bankruptcy filing, ratings had fallen to D by S&P (default status)

• rapid downgrade from investment-grade to junk status within days of the company’s bankruptcy filing was a key element of the Enron scandal, exposing the failure of credit rating agencies to detect the financial instability & fraud earlier  

Impact of the Scandal & Failure of Credit Ratings Agencies

• highlighted major flaws in the credit rating system

• raised concerns about conflicts of interest, as rating agencies were paid by the companies they rated, potentially compromising their objectivity

• delayed downgrade significantly contributed to the scale of the financial losses suffered by investors & creditors

• scandal led to regulatory changes (Sarbanes-Oxley Act of 2002) which aimed to enhance corporate governance, financial disclosures, & accountability of credit rating agencies & auditors