Ratings and Spreads

What are “Ratings and Spreads”?

Credit ratings are given to companies, governments, and institutions by credit agencies to show the ‘creditworthiness’ of their business or a particular debt product. There are 3 major credit agencies: Standard & Poors (S&P), Fitch and Moody’s and each have their own rating system. The agencies have their own methodologies (which are not directly comparable) but generally speaking, all have AAA as the highest (best) credit rating and D for the lowest.

Put simply, the function of the credit rating is to assess how likely an institution is to meet its debt obligations. This is based on factors such as the underlying business model, cash generation within, size of overall debt, and also the macroeconomic climate.

Companies request a credit rating from the credit agencies (and pay for this service) so that their debt can be quantified according to overall market and institution risk and sold more easily in the broader marketplace. A bond with a low credit rating will be less attractive to investors than a high credit rating and may need to offer to pay a higher interest rate to attract investors.

Credit spreads are calculations that show the difference between the yield on a bond (for example, a corporate bond) and a risk-free rate offered by a treasury bond of comparable maturity or duration. It typically shows the additional yield that is offered by a bond.

Rating Agencies and Rating Scales

Rating agencies play an important role in global credit markets in quantifying the risk associated with debt products. The market is dominated by three big global players – Standard & Poor (S&P), Moody’s Investor Service, and Fitch Ratings which together cover 95% of the rating business.

Ratings are assigned to governments, corporates, and other financial institutions and can be for an institution (an issuer rating) or a particular debt product (an issue rating). It is possible for an entity to have more than one credit rating depending on the number of debt products offered.

Each rating agency uses an independent methodology to calculate the credit rating, and although the scales are similar across the 3 agencies, they are not comparable due to differences in the underlying accounting methodology and risk assessments. However, all the agencies have a clear distinction between ‘investment grade’ and ‘non-investment grade credits. Often pension managers and other asset managers can usually invest in investment-grade credits only so it is a critical distinction.

S&P draws the line between BBB- rating (the lowest investment grade rating) and BB+, which is the highest speculative grade rating. Fitch Ratings does likewise. Moody’s draws the line between Baa3 and Ba1 rating, which is its highest non-investment grade rating. If an institution has its credit rating upgraded (downgraded) to investment (non-investment) grade it can have a significant impact on its yield and price.

Within investment grade rating, all the three rating agencies have 4 subcategories of such ratings for credits/bonds that represent the level of credit risk associated with the perceived risk of investment and likelihood of default.

Fitch Ratings and S&P’s highest (and best) credit rating is AAA. S&P describes this as an ‘extremely strong capacity to meet its financial commitments. Its lowest investment grade rating is BBB-. This is described as an adequate ability to meet commitments and notes that ‘adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation’.

Within speculative grade ratings, all the rating agencies have five subcategories ranging from substantial credit risk (BB+, BB and BB-) to high (B+, B and B-) very high (CCC+, CCC and CCC -), in or near default with the possibility of recovery (CC and C), and in default with little chance of recovery (DDD, DD and D – Fitch Ratings and SD&D – S&P) levels of credit risk. The last one is the lowest speculative-grade rating.

Credit ratings are a reflection of relative default risks and these risks increase non-linearly as creditworthiness declines. So creditworthiness for speculative-grade bonds is significantly worse than that of investment-grade bonds.

Credit Spreads

Turning to credit spreads, there are many different ways to describe the difference in yield between risk-free treasury bonds and riskier credits such as bonds. One way to quantify this is the nominal credit spread. This calculates the difference in Yield to Maturity (YTM) between a non-treasury item/bond and treasury security of the same duration.

As we know, yields tend to be higher, the longer the maturity of all bonds due to risk-weighted factors. Therefore, we typically witness an upward sloping yield curve in the market. However, the shape of the yield curve does vary and the size of the credit spread also varies across time.

In uncertain times, we tend to see higher credit spreads, as investors are feeling more risk averse and move into government bonds. On the other hand, in bull markets or times of low economic uncertainty, we see narrower or lower credit spreads as investors have a greater appetite for risk. The credit spread for high yield (junk) bonds is higher than the credit spread for investment grade bonds.

Ratings and Spreads – Two Examples

Given below is information to calculate the spread over treasuries for a 1-year bond. We compare the AA 1-year bond with the 1-year Treasury. The AA 1-year spread over treasuries is calculated below (0.75%).

Next, we calculate the expected YTM for a BBB rated bond. Further, we calculate the price of a 5-year zero-coupon bond issued by a BBB-rated entity, assuming that the face value of each bond is 100. Next, assume this bond has been downgraded to BBB -. We calculate the expected YTM and price of this bond too. The YTM is higher, as the credit spread is a lot higher.