Theratingsassigned bytheseagencies areletterratings.A
rating of AAA from Standard & Poor’s and Aaa from
Moody’s representsthehighestratinggrantedto firms that
areviewedashavingthelowestdefaultrisk.Asthedefault
risk increases, the ratings decrease toward D for firms in
default (Standard& Poor’s).AratingatoraboveBBB by
Standard & Poor’s is categorized as investment grade,
reflecting the view of the ratings agency that there is
relatively littledefaultrisk ininvesting inbondsissued by
these firms.
Estimating the Default Risk and Default Spread of a Firm
Thesimplestscenarioforestimatingthecostofdebtoccurs
whenafirmhaslong-termbondsoutstandingthatarewidely
traded.Themarketpriceofthebond,inconjunctionwithits
couponandmaturity,canservetocomputeayieldwecanuse
asthecostofdebt.Thisapproachworksforfirmsthathave
dozens of outstanding bonds that are liquid and trade
frequently.
Manyfirms havebondsoutstandingthatdonot tradeona
regular basis. Since these firms are usually rated, we can
estimate their costs of debt by using their ratings and
associateddefaultspreads.Thus,DisneywithaBBB+rating
hadacostofdebt1.25percenthigherthantheTreasurybond
ratein2004,sincethiswasthespreadtypicallypaidbyBBB+
rated firms (interpolated from BBB and A spreads) then.
Somecompanieschoosenottogetrated.Manysmallerfirms
and most private businesses fall into this category. While
ratingsagencieshavesprungupinmanyemergingmarkets,
therearestillanumberofmarketswherecompaniesarenot