216 Part 3 Financial Assets
Investor’s Service. Moody’s and S&P’s rating designations are shown in Table 7-2.^18
The triple- and double-A bonds are extremely safe. Single-A and triple-B bonds are
also strong enough to be called investment-grade bonds, and they are the lowest-
rated bonds that many banks and other institutional investors are permitted by law
to hold. Double-B and lower bonds are speculative, or junk, bonds; and they have
a signi! cant probability of going into default.Bond Rating Criteria
Bond ratings are based on! nancial ratios such as those discussed in Chapter 4 and
on various qualitative factors. The ratios, especially the debt and interest coverage
ratios, are generally the most important ratings determinants; but at times, other
factors that are expected to affect the ratios in the future take center stage. In 2008,
! rms’ exposures to subprime mortgages are leading to downgrades of! rms whose
ratios still look “reasonable.” Published ratios are, of course, historical—they show
the! rm’s condition in the past, whereas bond investors are more interested in the
! rm’s condition in the future. The qualitative factors can be divided into two
groups: factors that are related to the bond contract and all other factors. Follow-
ing is an outline of the determinants of bond ratings:- Financial Ratios. All of the ratios are potentially important, but the debt and
interest coverage ratios are key. The rating agencies’ analysts go through a
! nancial analysis along the lines discussed in Chapter 4 and forecast future
ratios along the lines described in the! nancial planning and forecasting chap-
ter. For the forecasts, the qualitative factors discussed next are important. - Qualitative Factors: Bond Contract Terms. Every bond is covered by a contract,
often called an indenture, between the issuer and the bondholders. The inden-
ture spells out all the terms related to the bond. Included in the indenture are
the maturity, the coupon interest rate, a statement of whether the bond is
secured by a mortgage on speci! c assets, any sinking fund provisions, and a
statement of whether the bond is guaranteed by some other party with a high
credit ranking. Other provisions might include restrictive covenants such as
requirements that the! rm not let its debt ratio exceed a stated level and that it
keep its times-interest-earned ratio at or above a given level. Some bond inden-
tures are hundreds of pages long, while others are quite short and cover just
the terms of the loan. - Miscellaneous Qualitative Factors. Included here are issues like the sensitivity of
the! rm’s earnings to the strength of the economy, the way it is affected by
in" ation, a statement of whether it is having or likely to have labor problems,
the extent of its international operations (including the stability of the coun-
tries in which it operates), potential environmental problems, and potential
antitrust problems. Today the most important factor is exposure to subprime
loans, including the dif! culty to determine the extent of this exposure as a
result of the complexity of the assets backed by such loans.
Investment-Grade
Bond
Bonds rated triple-B or
higher; many banks and
other institutional
investors are permitted by
law to hold only
investment-grade bonds.Investment-Grade
Bond
Bonds rated triple-B or
higher; many banks and
other institutional
investors are permitted by
law to hold only
investment-grade bonds.
Junk Bond
A high-risk, high-yield
bond.Junk Bond
A high-risk, high-yield
bond.(^18) In the discussion to follow, reference to the S&P rating is intended to imply the Moody’s and Fitch’s ratings as well.
Thus, triple-B bonds mean both BBB and Baa bonds; double-B bonds mean both BB and Ba bonds; and so forth.
Tabl e 7 - 2 Moody’s and S&P Bond Ratings
INVESTMENT GRADE JUNK BONDS
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC C
Note: Both Moody’s and S&P use “modifiers” for bonds rated below triple A. S&P uses a plus and minus
system. Thus, A+ designates the strongest A-rated bonds; A-, the weakest. Moody’s uses a 1, 2, or 3
designation, with 1 denoting the strongest and 3 denoting the weakest; thus, within the double-A category,
Aa1 is the best, Aa2 is average, and Aa3 is the weakest.