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Bond Ratings Mitchell Dietrich BA 543 May 12, 2005.

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1 Bond Ratings Mitchell Dietrich BA 543 May 12, 2005

2 What are Bond Ratings? A bond rating is an opinion of the ability of issuer to honor their financial obligation to make coupon or principle payments. The higher the rating the less likely an issuer will default.

3 Who issues bond ratings? Moody’s Investor Services 1909 – John Moody published a book of Railroad Investments that included concise analysis of their relative investment quality. Standard & Poor’s Corporation 1860 – Henry Varnum Poor began supplying European investors with financial information on their holdings in the developing infrastructure of America Fitch Ratings 1913 – John Knowles Finch published “Fitch Bond Book” and other books on financial markets. Fitch is credited with introducing the AAA through D rating system now used

4 Comparison of Bond Ratings

5 Investment Grade Bonds Highest Grade - AAA These bonds are judged to be of the best quality. They carry the smallest degree of risk. Interest payments are protected by an exceptionally stable margin and principal is secure. The issuer’s capacity to meet its financial obligation on the bond is extremely strong. High Grade – AA These bonds are judged to be of high quality by all standards. Margins of protection may not be as large as in AAA securities. The issuer’s capacity to meet its financial obligation on the bond is very strong. Upper Medium Grade – A These bonds possess many favorable investment attributes. Factors giving security to principal and interest are considered adequate. Although these bonds are somewhat more susceptible to the adverse effects of changing economic conditions, the issuer’s capacity to meet its financial obligations is strong. Medium Grade – BBB The bonds lack outstanding investment characteristics and have speculative characteristics as well. Adverse economic conditions are more likely to lead to a weakened capacity of the issuer to meet its financial commitment.

6 Speculative Grade Bonds Distinctly Speculative Grades- BB & B The future of these bonds cannot be considered as well assured. These bonds face exposure to adverse business or economic conditions which could lead to an issuer’s inadequate capacity to meet its financial commitment. Predominately Speculative Grades- CCC and below These bonds are of poor standing. Such issues may be in default, or there may be elements of danger with respect to principal or interest. These bonds are vulnerable to nonpayment, and are dependent upon favorable economic conditions for the issuer to meet its financial commitment.

7 Estimated Default Probabilities

8 Short Term Ratings Short-term ratings are opinions of the ability of issuers to honor short- term financial obligations. Ratings may be assigned to issuers, short-term programs or to individual short-term debt instruments. Such obligations generally have an original maturity not exceeding thirteen months, unless explicitly noted. Investment Grade P-1 Issuers rated Prime-1 have a superior ability to repay short-term debt obligations. P-2 Issuers rated Prime-2 have a strong ability to repay short-term debt obligations. P-3 Issuers rated Prime-3 have an acceptable ability to repay short-term obligations. Speculative Grade NP Issuers rated Not Prime do not fall within any of the Prime rating categories

9 Why are ratings important to Issuers?

10 They are independent verification of their credit worthiness. They allow the issuers to “tell their story.” They are a marketing tool that can be used to attract investors. The higher the rating, the lower their borrowing costs. Provide potential investors with an unbiased opinion regarding their ability to meet obligations.

11 Why are ratings important to Investors?

12 They rely on ratings as an indicator the risk of default for a particular bond investment. The ratings influence the price and the yield of a bond The rating provides investors with comparative ranking between bonds that they would otherwise be either impractical or impossible for them to get with their own resources.

13 Rating Process 1. Bond Issuer requests that a rating company determine a rating. 2. Rating Company forms an analytical team that: –gathers information sufficient to evaluate risk to investors who might own or buy a given security. –develops a conclusion in committee on the appropriate rating 3. The Rating Committee then issues a rating decision based on the report of the analytical team. 4. The new rating then is monitored over time and adjusted as appropriate to reflect changes in the probability the issuer will default.

14 What information is used in determining a bond rating?

15 Publicly available data, e.g., annual reports. Prospectuses, offering circulars, offering memoranda, trust deeds, or indentures of particular securities. Market data, e.g., stock price trends, trading volume, data on bond price spreads. Economic data from industry groups, associations or bodies, such as the World Bank. Data from agencies, such as central banks, ministries, or regulators. Books or articles from academic sources, financial journals, news reports. Discussions with expert sources in industry, government, or academia. Data that may come from meetings or conversations with the debt issuer.

16 What information is used in determining a municipal bond rating?

17 Stability of tax base Demographic Factors –growth of population –Financial capacity of population Governmental Factors

18 Rating Changes Rating are adjusted as likelihood of default is upgraded or downgraded –Issues which are being reviewed for possible changes are placed on a credit watch list Ratings are much more likely to be downgraded because of: –Event risk –Leveraged buyout or recapitalization –Other reasons – Fallen Angels

19 Ratings Transition Matrices

20 What happened to Ford and GM? Ford – The downgrade to non-investment grade (BB+ from BBB-) reflects our skepticism about whether management’s strategies will be sufficient to counteract mounting competitive challenges. (S & P ) GM – The downgrade to non-investment grade (BB from BBB-) reflects our conclusion that management’s strategies may be ineffective in addressing GM’s competitive disadvantages..... The effort by Kirk Kerkorian’s Tracinda Corp. to increase its ownership stake in GM represents an additional uncertainty; however this is not a factor at all in the current rating action. (S & P)

21 Questions?

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