Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIII. Valuation of Future
Cash Flows- Interest Rates and Bond
Valuation
© The McGraw−Hill^247
Companies, 2002The highest rating a firm’s debt can have is AAA or Aaa, and such debt is judged to
be the best quality and to have the lowest degree of risk. For example, the 100-year Bell-
South issue we discussed earlier was rated AAA. This rating is not awarded very often;
AA or Aa ratings indicate very good quality debt and are much more common. The low-
est rating is D, for debt that is in default.
Beginning in the 1980s, a growing part of corporate borrowing has taken the form of
low-grade, or “junk,” bonds. If these low-grade corporate bonds are rated at all, they are
rated below investment grade by the major rating agencies. Investment-grade bonds are
bonds rated at least BBB by S&P or Baa by Moody’s.
Rating agencies don’t always agree. For example, some bonds are known as
“crossover” or “5B” bonds. The reason is that they are rated triple-B (or Baa) by one rat-
ing agency and double-B (or Ba) by another, a “split rating.” For example, in June 1996,
TCI Communications sold one such issue of three-year notes rated BBB by S&P and Ba
by Moody’s. Thus, one agency rated the bonds as medium grade, while the other rated
them as junk.
A bond’s credit rating can change as the issuer’s financial strength improves or deteri-
orates. For example, in 2001, Moody’s downgraded Lucent Technology’s long-term debt
from Baa3 to Ba1, pushing it from investment-grade into junk bond status. Bonds that
drop into junk territory like this are called fallen angels. Why was Lucent downgraded? A
Low-Quality, Speculative,
Investment-Quality Bond Ratings and/or “Junk” Bond Ratings
High Grade Medium Grade Low Grade Very Low Grade
Standard & Poor’s AAA AA A BBB BB B CCC CC C D
Moody’s Aaa Aa A Baa Ba B Caa Ca C DMoody’s S&P
Aaa AAA Debt rated Aaa and AAA has the highest rating. Capacity to pay interest and principal
is extremely strong.
Aa AA Debt rated Aa and AA has a very strong capacity to pay interest and repay principal.
Together with the highest rating, this group comprises the high-grade bond class.
A A Debt rated A has a strong capacity to pay interest and repay principal, although it is
somewhat more susceptible to the adverse effects of changes in circumstances and
economic conditions than debt in high-rated categories.
Baa BBB Debt rated Baa and BBB is regarded as having an adequate capacity to pay interest
and repay principal. Whereas it normally exhibits adequate protection parameters,
adverse economic conditions or changing circumstances are more likely to lead to a
weakened capacity to pay interest and repay principal for debt in this category than in
higher-rated categories. These bonds are medium-grade obligations.
Ba;B BB;B Debt rated in these categories is regarded, on balance, as predominantly speculative
Caa CCC with respect to capacity to pay interest and repay principal in accordance with the
Ca CC terms of the obligation. BB and Ba indicate the lowest degree of speculation, and CC
and Ca the highest degree of speculation. Although such debt is likely to have some
quality and protective characteristics, these are outweighed by large uncertainties or
major risk exposures to adverse conditions. Some issues may be in default.
C C This rating is reserved for income bonds on which no interest is being paid.
D D Debt rated D is in default, and payment of interest and/or repayment of principal is in
arrears.CHAPTER 7 Interest Rates and Bond Valuation 217Want to know what
criteria are commonly
used to rate corporate
and municipal bonds?
Go to http://www.
standardandpoors.com,
http://www.moodys.com,or
http://www.fitchinv.com.At times, both Moody’s and S&P use adjustments to these ratings. S&P uses plus and minus signs: Ais the strongest A rating and Athe
weakest. Moody’s uses a 1, 2, or 3 designation, with 1 being the highest.