1. Bond Ratings and Agencies ~ Corporate Bonds~ Ya-Chien Yang

2. Agenda 1. Overview of Bond Ratings and Its Agencies 2. Corporate Bond Rating Process and Approach 3. Bonds in Default 4. The Effect of Credit Rating

3. Bond Rating – What is it… Definition of bond ratings( Credit ratings ) : Organizations like Standard and Poor's and Moody's rate the riskiness of corporate, municipal, and government issued securities and gives each security a Bond Rating. A credit rating is an opinion about the future, not a statement of fact. A bond rating is not a recommendation to purchase, sell, or hold a security inasmuch as it does not comment on market price or suitability for a particular investor. Ratings are of value only as long as they are credible. Definition of bond ratings( Credit ratings ) : Organizations like Standard and Poor's and Moody's rate the riskiness of corporate, municipal, and government issued securities and gives each security a Bond Rating. A credit rating is an opinion about the future, not a statement of fact. A bond rating is not a recommendation to purchase, sell, or hold a security inasmuch as it does not comment on market price or suitability for a particular investor. Ratings are of value only as long as they are credible.

4. Bond Rating Agencies Rating agencies receive regulatory scrutiny from Congress and SEC (Securities and Exchange Commission). Certified agencies: -- In 1975, SEC created NRSROs (Nationally Recognized Statistical Rating Organizations). There are currently five NRSROs: A.M. Best Company, Inc. (Best’s) Dominion Bond Rating Service Ltd. (DBRS: jointed in2003) Fitch, Inc. (FITCH) Moody's Investors Service (Moddy’s) the Standard & Poor's Division of the McGraw Hill Companies Inc. (S&P) -- Bonds Issuers Pay to be rated Non-certified agencies -- about 150 companies worldwide -- usually no fees charged Rating agencies receive regulatory scrutiny from Congress and SEC (Securities and Exchange Commission). Certified agencies: -- In 1975, SEC created NRSROs (Nationally Recognized Statistical Rating Organizations). There are currently five NRSROs: A.M. Best Company, Inc. (Best’s) Dominion Bond Rating Service Ltd. (DBRS: jointed in2003) Fitch, Inc. (FITCH) Moody's Investors Service (Moddy’s) the Standard & Poor's Division of the McGraw Hill Companies Inc. (S&P) -- Bonds Issuers Pay to be rated Non-certified agencies -- about 150 companies worldwide -- usually no fees charged

5. The Tress biggest rating agencies Moody's Investors Services (Moody's) -- the U.S. operating company of Moody's Corporation -- ratings and analysis track more than $35 trillion of debt -- maintains offices in most of the world's major financial centers and employs more than 2,000 people in 19 countries. -- The company's famous letter ratings (ranging from Aaa to C), invented by John Moody in 1909, are still used today. Standard & Poor's (S&P) -- a business segment of publishing house McGraw-Hill -- found in 1860 and has been assigning ratings to corporate bonds since 1923 -- operations in 20 countries -- is best known for its US-based S&P 500 and the Australian S&P 200 stock market indexS&P 500S&P 200 Fitch Ratings (FITCH) -- is an international credit rating company dual-headquartered in New York City and London -- found in New York City as the Fitch Publishing Company, merged with London-based IBCA Limited in 1997. Fitch became owned by the French holding company, Fimalac S.A., which acquired IBCA in 1992. -- In the 1920s, Fitch introduced the now familiar "AAA" to "D" rating scale Moody's Investors Services (Moody's) -- the U.S. operating company of Moody's Corporation -- ratings and analysis track more than $35 trillion of debt -- maintains offices in most of the world's major financial centers and employs more than 2,000 people in 19 countries. -- The company's famous letter ratings (ranging from Aaa to C), invented by John Moody in 1909, are still used today. Standard & Poor's (S&P) -- a business segment of publishing house McGraw-Hill -- found in 1860 and has been assigning ratings to corporate bonds since 1923 -- operations in 20 countries -- is best known for its US-based S&P 500 and the Australian S&P 200 stock market indexS&P 500S&P 200 Fitch Ratings (FITCH) -- is an international credit rating company dual-headquartered in New York City and London -- found in New York City as the Fitch Publishing Company, merged with London-based IBCA Limited in 1997. Fitch became owned by the French holding company, Fimalac S.A., which acquired IBCA in 1992. -- In the 1920s, Fitch introduced the now familiar "AAA" to "D" rating scale

6. Corporate Bond Rating Process Primary question: Can the firm service its debt in a timely manner? Three main areas are examined: 1. Bond indenture provisions 2. Company’s financial resources 3. Future earning power Where do bond rating agencies get information? 1. published reports, ex: annual and quarterly reports and bond registration statement filed with SEC 2. “interviews” company management (key operating and financial figures) 3. talk with firm’s competitors and review trade journals for articles about firm and possible innovations Agencies review its ratings on a regular base. Primary question: Can the firm service its debt in a timely manner? Three main areas are examined: 1. Bond indenture provisions 2. Company’s financial resources 3. Future earning power Where do bond rating agencies get information? 1. published reports, ex: annual and quarterly reports and bond registration statement filed with SEC 2. “interviews” company management (key operating and financial figures) 3. talk with firm’s competitors and review trade journals for articles about firm and possible innovations Agencies review its ratings on a regular base.

7. How bond ratings work Rating and yield:Rating and yield:

8. FITCHStandard & Poor’sMoody’sMeaning AAA AaaExtremely strong: highest credit rating, virtually no risk of default AA+ AA AA- Aa1 Aa2 Aa3 Very strong: high likelihood of repayment, low risk of insolvency A+ A A- A1 A2 A3 Strong: adequate capacity to meet financial commitments; risk of insolvency still low BBB+ BBB BBB- Baa1 Baa2 Baa3 Adequate: adequate capacity to meet financial commitments; medium risk of insolvency (speculative characteristics, vulnerable to changes in economic conditions) BB+ BB BB- Ba1 Ba2 Ba3 Somewhat weak: moderate capacity to meet financial commitments, higher risk of insolvency B+ B B- B1 B2 B3 Weak: no guarantee as to ability to meet financial commitments, high risk of insolvency CCC CC Caa Ca Vulnerable: barley sufficient credit standing, very high risk of insolvency SD/D CUnable to meet payment obligations: in default or insolvent Rating Systems and Symbols Source from: http://www.hk24.de/HK24/HK24/produktmarken/index.jsp?url=http%3A//www.hk24.de/HK24/HK24/servicemarken/englische_website/stock_ex change/credit_ratings.jsp http://www.hk24.de/HK24/HK24/produktmarken/index.jsp?url=http%3A//www.hk24.de/HK24/HK24/servicemarken/englische_website/stock_ex change/credit_ratings.jsp

9. Bond Classification Investment Grade: refers to bonds rated Baa/BBB or better. Non- Investment Grade: -- High-Yield Bonds ( junk bond): refers to bonds rated below Baa/BBB a corporate bond, that has a higher yield (compared to investment grade debt) because of a high perceived credit risk (default risk). -- Bond in Default: a bond issuer is unwilling or unable to pay their debt obligations. In corporate finance, a default is typically a prelude to bankruptcy. Ex: Enron and WorldCom “Fallen Angels": Bonds that were originally issued at investment grade and later downgraded to non-investment grade status. Ex: GM and Ford Investment Grade: refers to bonds rated Baa/BBB or better. Non- Investment Grade: -- High-Yield Bonds ( junk bond): refers to bonds rated below Baa/BBB a corporate bond, that has a higher yield (compared to investment grade debt) because of a high perceived credit risk (default risk). -- Bond in Default: a bond issuer is unwilling or unable to pay their debt obligations. In corporate finance, a default is typically a prelude to bankruptcy. Ex: Enron and WorldCom “Fallen Angels": Bonds that were originally issued at investment grade and later downgraded to non-investment grade status. Ex: GM and Ford

10. Default Risk / Credit Risk Default risk means the risk that companies will be unable to pay the contractual interest or principal on their debt obligations. Credit ratings are meant to capture and categorize credit risk. * interest coverage ratios “How much money does the company generate each year in order to fund the annual interest on its debt?” * capitalization ratios “ How much interest-bearing debt does the company carry in relation to the value of its assets?” Default risk means the risk that companies will be unable to pay the contractual interest or principal on their debt obligations. Credit ratings are meant to capture and categorize credit risk. * interest coverage ratios “How much money does the company generate each year in order to fund the annual interest on its debt?” * capitalization ratios “ How much interest-bearing debt does the company carry in relation to the value of its assets?”

11. One-Year Ratings Transition Matrix One-year ratings migration probabilities based upon bond rating data from 1981-2000. Data is adjusted for rating withdrawals. Source: Standard & Poor's. original rating probability of migrating to rating by year end (%) AAAAAABBBBBBCCCDefault AAA93.665.830.400.080.030.00 AA0.6691.726.940.490.060.090.020.01 A0.072.2591.765.190.490.200.010.04 BBB0.030.254.8389.264.440.810.160.22 BB0.030.070.446.6783.317.471.050.98 B0.000.100.330.465.7784.193.875.30 CCC0.160.000.310.932.0010.7463.9621.94 Default0.00 100.00

12. The Effect of Credit Rating Ratings provide additional information to the market. ex: the quality of a firm beyond publicly available information The impact of a rating downgrade or upgrade: -- affect on bond prices -- also affect on stock prices Credit ratings may affect relationships with third party, including the employees of the firm, suppliers to the firm, or customers of the firm. Credit ratings might affect a manager’s reputation. A high rating allows the creditor a competitive advantage and they get easily good condition for credit capital Ratings provide additional information to the market. ex: the quality of a firm beyond publicly available information The impact of a rating downgrade or upgrade: -- affect on bond prices -- also affect on stock prices Credit ratings may affect relationships with third party, including the employees of the firm, suppliers to the firm, or customers of the firm. Credit ratings might affect a manager’s reputation. A high rating allows the creditor a competitive advantage and they get easily good condition for credit capital

13. Conclusions and Questions Bond rating agencies need to be aware of the effect of relationships with client firms. Chose more than one rating agencies when getting credit ratings. Questions?