Bond Ratings

Firms frequently pay to have their debt rated. The two leading bond-rating firms are Moody's Investors Service and Standard & Poor's. The debt ratings depend upon (1) the likelihood that the firm will default and (2) the protection afforded by the loan contract in the event of default. The ratings are constructed from information supplied by the corporation, primarily the financial statements of the firm. The rating classes are shown in the accompanying box.

The highest rating debt can have is AAA or Aaa. Debt rated AAA or Aaa is judged to be the best quality and to have the lowest degree of risk. The lowest rating is D, which indicates that the firm is in default. Since the 1980s, a growing part of corporate borrowing has taken the form of low-grade bonds. These bonds are also known as either high-yield bonds or junk bonds. Low-grade bonds are corporate bonds that are rated below investment grade by the major rating agencies (that is, below BBB for Standard & Poor's or Baa for Moody's).

Bond ratings are important, because bonds with lower ratings tend to have higher interest costs. However, the most recent evidence is that bond ratings merely reflect bond risk. There is no conclusive evidence that bond ratings affect risk.11 It is not surprising that the stock prices and bond prices of firms do not show any unusual behavior on the days around a rating change. Because the ratings are based on publicly available information, they probably do not, in themselves, supply new information to the market.12

nM. Weinstein, "The Systematic Risk of Corporate Bonds," Journal of Financial and Quantitative Analysis (September 1981); J. P. Ogden, "Determinants of Relative Interest Rate Sensitivity of Corporate Bonds," Financial Management (Spring 1987); and F. Reilly and M. Joehnk, "The Association between Market-Based Risk Measures for Bonds and Bond Ratings," Journal of Finance (December 1976). 12M. Weinstein, "The Effect of a Ratings Change Announcement on Bond Price," Journal of Financial Economics 5 (1977). However, Robert W. Holthausen and Richard W. Leftwich, "The Effect of Bond Rating Changes on Common Stock Prices," Journal of Financial Economics 17 (September 1986), find that bond rating downgrades are associated with abnormal negative returns of the stock of the issuing firm.

Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition

V. Long-Term Financing

20. Long-Term Debt

© The McGraw-H Companies, 2002

Chapter 20 Long-Term Debt

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