The Ratings Process

The process of rating a bond starts when a company requests a rating from the ratings agency. This request is usually precipitated by a desire on the part of the company to issue bonds. While ratings are not a legal pre-requisite for bond issues, it is unlikely that investors in the bond market will be willing to buy bonds issued by a company that is not well known and has shown itself to be unwilling to put itself through the rigor of a bond rating process. It is not surprising, therefore, that the largest number of rated companies are in the United States, which has the most active corporate bond markets, and that there are relatively few rated companies in Europe, where bank lending remains the norm for all but the largest companies.

The ratings agency then collects information from both publicly available sources, such as financial statements, and the company itself, and makes a decision on the rating. If it disagrees with the rating, the company is given the opportunity to present additional information. This process is presented schematically for one ratings agency, Standard and Poors (S&P), in Figure 3.9:

Standard And Poor Rating Process

The ratings assigned by these agencies are letter ratings. A rating of AAA from Standard and Poor's and Aaa from Moody's represents the highest rating granted to firms that are viewed as having the lowest default risk. As the default risk increases, the ratings decrease toward D for firms in default (Standard and Poor's). Table 3.1 provides a description of the bond ratings assigned by the two agencies.

Table 3.1: Index of Bond Ratings

Standard and Poor's

Moody's

AAA The highest debt rating assigned. The borrower's capacity to repay debt is extremely strong.

Aaa Judged to be of the best quality with a small degree of risk.

AA Capacity to repay is strong and differs from the highest quality

Aa High quality but rated lower than Aaa because margin of protection

only by a small amount.

may not be as large or because there may be other elements of long-term risk.

A Has strong capacity to repay;

Borrower is susceptible to adverse effects of changes in circumstances and economic conditions.

A Bonds possess favorable investment attributes but may be susceptible to risk in the future.

BBB Has adequate capacity to repay, but adverse economic conditions or circumstances are more likely to lead to risk.

Baa Neither highly protected nor poorly secured; adequate payment capacity.

BB,B, Regarded as predominantly CCC, speculative, BB being the least CC speculative andd CC the most.

Ba Judged to have some speculative risk.

B Generally lacking characteristics of a desirable investment; probability of payment small.

D In default or with payments in arrears.

Caa Poor standing and perhaps in default.

Ca Very speculative; often in default. C Highly speculative; in default.

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