Looking to understand how credit ratings are calculated and their impact on investing? Learn the differences between fallen angels and rising stars, and how business and financial risks are evaluated in the credit rating process.
Key Insights
- Credit rating refers to a quantified assessment of a borrower's creditworthiness in general terms or with respect to a particular financial obligation.
- The global credit rating industry is dominated by three agencies: Moody’s, S&P Global, and Fitch Ratings.
- A 'Fallen Angel' refers to a bond initially given an investment-grade rating but has since been reduced to junk bond status due to deteriorating financial conditions of the issuer.
- A 'Rising star' refers to a bond rated as a junk bond but could become investment grade because of improvements in the issuing company's credit quality.
- Business risk and financial risk are two types of warning signs considered in credit rating calculation. Business risk evaluates a company's ability to generate revenue to cover expenses, whereas financial risk evaluates a company's ability to manage its debt and financial leverage.
- Rating agencies combine business and financial risk assessments to generate an accurate credit rating for industries and companies.
Credit Rating Tiers
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Investment Grade
AAA to BBB- — low default risk, eligible for many institutional portfolios.
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Speculative (Junk)
BB+ and below — higher yields to compensate for higher default risk.
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Big Three Agencies
S&P, Moody's, Fitch — each has its own scale and methodology.
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Drives Borrowing Cost
Lower rating = higher interest rate to issue bonds.
The term credit rating refers to a quantified assessment of a borrower's creditworthiness in general terms or with respect to a particular debt or financial obligation.
The global credit rating industry is highly concentrated, with three agencies controlling nearly the entire market: Moody’s, S&P Global, and Fitch Ratings.
Credit Rating Matrix:
Fallen Angel—a bond that was initially given an investment-grade rating but has since been reduced to junk bond status. The downgrade is caused by a deterioration in the financial condition of the issuer.
Rising star—a bond that is rated as a junk bond but could become investment grade because of improvements in the issuing company's credit quality.
- By investing during a security's temporary fallen angel status, investors can benefit from an opportunity to generate strong returns
- By identifying a rising star bond at the right stage of the market cycle, investors can earn higher yields from a firm that is more likely to meet its financial obligations
Financial risk and business risk are two different types of warning signs that are considered in credit rating calculation.
Business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses. To evaluate business risk we would look into:
- Country risk
- Industry dynamics
- Company position
- Profitability/peer group analysis
Financial risk refers to a company's ability to manage its debt and financial leverage. To evaluate the financial risk we consider:
- Accounting policy of this company
- Financial policy and governance
- Cash flow adequacy
- Capital structure
- Liquidity
Business and Financial Risk Combined help the rating agencies to come up with the accurate credit rating for the industry and companies.
