Subject 3. Credit Ratings

The rating agencies (Moody's, S&P, and Fitch) rate both issuers and issues. Issuer ratings are meant to address an issuer's overall creditworthiness - its risk of default. Ratings for issues incorporate such factors as rankings in the capital structure.

Notching

A company's credit rating corresponds to its senior unsecured obligations. A rating agency may notch up secure debt from the company credit rating and notch down subordinated debt. A credit rating agency's notching policy primarily intends to reflect the relative recovery prospects of different instruments issued by the same issuer.

Risks in Relying on Agency Ratings

There are risks in relying too much on credit agency ratings.

Because creditworthiness is dynamic, initial/current ratings do not necessarily reflect the evolution of credit quality over an investor's holding period. Importantly, bond ratings do not always capture price risk because valuations often adjust before ratings change and the notching process may not adequately reflect the price decline of a bond that is lower ranked in the capital structure. Similarly, because ratings primarily reflect the probability of default but not necessarily the severity of loss given default, bonds with the same rating may have significantly different expected losses. And like analysts, credit rating agencies may have difficulty forecasting certain credit-negative outcomes, such as adverse litigation, leveraging corporate transactions, and such low likelihood/high severity events as earthquakes and hurricanes.

User Contributed Comments 3

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johntan1979: From previous module: credit spread widens before a downgrade.
HolzGe1: The notes dont mention the rating agency gets paid by the issuer, so they're about as "independent" as the company's auditor :S

Gotta love financial markets!
cfaguy: promote capital market integrity, it's the same as asking non-believer to worship, but different fields "Khalifa."