Junk Bond Rating

6 Key excerpts on "Junk Bond Rating"

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  eBook - ePub

  The Only Guide to Alternative Investments You'll Ever Need

  The Good, the Flawed, the Bad, and the Ugly

  • Larry E. Swedroe, Jared Kizer(Authors)
  • 2010(Publication Date)
  • Bloomberg Press

    (Publisher)

  PART 2

  The Flawed

  Passage contains an image

  7

  High-Yield (Junk) Bonds

  THE SEARCH FOR higher returns often leads investors to the world of high-yield bonds, also called junk bonds. Junk bonds have lower credit ratings (below BBB from Standard & Poor’s and below Baa from Moody’s) and higher yields than more creditworthy securities. Those higher yields, of course, are compensation for an investor’s willingness to take incremental risks.

  TABLE 7.1

  describes the risks connoted by each rating in more detail.

  Note that Moody’s describes any bond with a rating of Ba or below as speculative—differentiating it from a sound investment. Logically, the more speculative (risky) the investment, the greater the yield needs to be to entice investors to assume this incremental risk.

  A fixed-income instrument plays three primary roles in a portfolio: to serve as a liquid reserve in the event of emergencies; to generate a stable cash flow; and to provide the portfolio with stability, allowing investors to take equity risk.

  As we will demonstrate, junk bonds are too risky and too exposed to equity risk to serve these purposes. However, they do possess two other characteristics that should be analyzed before deciding against this asset class.

  First, junk bonds offer the potential for high returns. Second, they also exhibit nonperfect correlation (a correlation of less than 1) with equities, U.S. government securities, and the securities of corporate bonds with the highest credit ratings (AAA and AA). This suggests the possibility that junk bonds might have some diversification benefits.

  Table 7.1 Credit Ratings for Standard & Poor’s and Moody’s

  S&P 500	Moody’s	Description of Risk
  AAA	Aaa	Almost riskless, just below U.S. Treasury obligations. Future changes unlikely to impair debt rating.
  AA	Aa	High quality. Future changes may impair rating.
  A	A	Good quality. Susceptible to impairment of rating.
  BBB	Baa	Medium quality; lowest investment grade. Have some speculative characteristics

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  The Management of Bond Investments and Trading of Debt

  • Dimitris N. Chorafas(Author)
  • 2005(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  Also significant in terms of information regarding creditworthiness of debt instru-ments are statistics regarding the rating of new bond issues. Such statistics vary from one country to the next, but the way to bet is that all issuers try to obtain a higher rating than their debt justifies. For instance, they target A or better, by sugar-coating their offer to the market. By means of: Offering some collateral, Having a guarantor, or Retaining the worst tranche of the security. There are also an amount of bonds, usually less than 10% of total issues, which are unrated. This does not necessarily mean that they are poor quality. Some issuers don’t like to pay for credit rating, but without a dependable source evaluating the creditworthiness of issuer and issue, the investor is in uncharted waters. Many companies are capitalizing on the investor’s fear of the unknown in an effort to promote their debt instruments even if the rating is low. Sometimes, this bears fruits. For instance, since the mid-1980s when junk bonds were aggressively pushed in the capital market, the pace of their sales has increased. In early 2004, in the Euro area, the volume of non-investment grade bonds amounted to around 50 billion euro, which is 500% more than at the beginning of monetary union on 1 January 2002. Particularly in Europe, the telecommunications sector has initially been the dom-inant force in non-investment-grade securities. At the end of 1999, it roughly held a 50% share of the European market for junk bonds. Subsequently, however, consoli-dation in the technology sector and the increasing involvement of companies from other industrial sectors has seen to it that by the beginning of 2004 the telecoms share in junk bond issues fell to about 7%.

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  Introduction to Financial Mathematics

  With Computer Applications

  • Donald R. Chambers, Qin Lu(Authors)
  • 2021(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  Credit ratings are important metrics within the financial industry. Rating agencies analyze the credit risk of most publicly traded credit-based securities. Rating agencies are for-profit firms that in recent decades have been primarily paid by firms to rate their new securities rather than being paid by investors subscribing to their publications (as was common decades ago). In the United States, the SEC (Securities and Exchange Commission) recognizes several NRSROs (Nationally Recognized Statistical Rating Organizations) that may provide information that may be relied upon for regulatory purposes. The credit rating industry has consolidated into three major rating agencies: Moody’s, S&P, and Fitch. This book uses the notation of Moody’s: Aaa: highest rating with almost no chance of default. Aa1–Baa3: investment grade bonds. Ba1–Caa3: high yield or junk bonds. C / (sometimes referred to as D): lowest rating; used for bonds in default. Note that Aa indicates greater safety than A and similarly Baa better safety than Ba. Most rating agencies provide further detail. For example, the highest Moody’s rating within the Baa category is Baa1 and the lowest rating within the Baa category is Baa3. Modeling the probability of default is the starting point for credit rating and credit risk modeling. The default probability is one of the most important factors in credit derivative pricing. This section defines various default probabilities and discusses their relations. If one knows the value of one type of default probability, it can be used to derive the rest. 8.1.1 Types of Default Probabilities This section introduces five default probabilities from a mathematical perspective. It is assumed that default can only occur once. Let t be a positive real number which represents time t

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  FINANCIAL SYSTEM, FINANCIAL DEVELOPMENT AND FIRM SURVIVAL:

  PERSPECTIVES FROM TURKISH FINANCIAL SYSTEM AND GLOBALIZATION

  • Adnan Kara, Ramazan SAYAR(Authors)
  • 2020(Publication Date)
  • Peter Lang Group

    (Publisher)

  Therefore, the not repayment of the credits issued or the high risks in this regard impede the healthy functioning of financial markets and create important problems that lead the crisis. At this point, every market participant should be aware of the risk it takes for the markets to function properly (Berker, 2003). With this feature, credit rating provides convenience to market participants for assessing the risks of financial assets and making decisions. Although credit rating is a subjective opinion, the ratings may affect investors’ decisions. At the same time, financial resources related to investments such as doing business by local investors, borrowing from abroad, buying and selling bonds, and financing large infrastructure projects requiring external financing are all affected by the ratings given by these institutions (Karagöl, 2013: 8). The major source of financing for large-scale investments in the financial markets is government bonds. Government bonds, which account for more than 40% of the globally issued bond stocks, are now an important investment option in the hands of investors. For this reason, the existence of globally accepted and consis- tent credit rating criteria that can help investors in their investment decisions is very important (Dimitrijevic, 2012: 2). On the other hand, although the purchase of the securities depends on the investor’s attitude about risk, it is observed that the investors generally turn to Yıldız and Günsoy 66 the lower-risk securities. However, this does not mean that high-risk securi- ties cannot be marketed. If the risk is compensated, the possibility of marketing high-risk securities increases (Özdinç, 1999: 9–10). In financial markets, credit ratings are important for lenders as well as for borrowers to eliminate serious risks. Borrowers, that is, the issuers of any debt instrument, should also be aware of the risk it takes.

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  Private Ratings, Public Regulations

  Credit Rating Agencies and Global Financial Governance

  • A. Kruck(Author)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Ideally, credit rating agencies constitute an early warning system, a form of market control, and a protection institution (Gras 2003: 20–1; Hillebrand 2001: 163). Credit ratings are crucial tools used by most investors for making investment decisions based on a calculation of returns on invest- ment vs. risks of investment. The higher the default risk, that is, the lower-rated the financial title, the higher will be the interest rates and thus the returns on investment (Gras 2003: 7; Gündling and Everling 1994: 728). Through their ratings, credit rating agencies codetermine the cost of borrowing for a wide array of private and public financial The Regulatory Use of Credit Ratings 29 market actors around the world. A good rating increases the accept- ance for a certain bond, makes the bond attractive to a broader circle of investors, or may even be a prerequisite for access to capital markets by making the issue of a bond possible in the first place. Ratings docu- ment the creditworthiness of an issuer and thus create trust, which is a prerequisite for striking (good) credit deals (von Randow 1996: 548). On the other hand, bad ratings or (sudden) rating downgrades lead to steeply increasing interest rates and may even prevent actors (e.g. business enterprises, or even developing countries) from getting access to private capital (Gras 2003: 32; Hillebrand 2001). As ratings have considerable influence on the interest of a bond (the risk pre- mium), bad ratings or rating downgrades make the mobilization of capital more difficult and more expensive. A bad rating may even have an impact on the overall financing opportunities of issuers beyond borrower–lender relationships, since ratings frequently affect stock market notation and client and/or supplier relationships. In short, the potential damage from bad ratings is considerable (Gras 2003: 17–18; Peters 2001: 30; Randow 1996: 567–8).

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  The New Masters of Capital

  American Bond Rating Agencies and the Politics of Creditworthiness

  • Timothy J. Sinclair(Author)
  • 2014(Publication Date)
  • Cornell University Press

    (Publisher)

  This view certainly seems to be behind Detroit city officials’ frustration with bond raters. The officials insisted that Moody’s ought to have considered whether Detroit paid its debts and controlled its budget, rather than make judgments about the future population base or quality of life in the jurisdiction. Such matters would usually be subjects for political judgment, social science, or speculation. 52 The intersubjective belief that quantitative data is the only criterion of credit rating, or that it should be, has fostered research into variables that would help an issuer secure a higher rating and therefore access to cheaper credit. 53 Outputs Typically, at the end of the rating committee meeting, a rating is established. A variety of rating scales are available for different financial instruments. The debt ratings on bonds are the most commonly recognized, but S&P also has scales for commercial paper, preferred stock, certificates of deposit, money market funds, mutual bond funds, and insurance company claims-paying ability. S&P and Moody’s bond rating scales are given in table 2, along with brief definitions of these ratings. In the scales, an important distinction is made between investment and speculative “grades.” These grades, which neatly cleave the rating scale in two, are a result of securities legislation passed during the 1930s, which permits fiduciaries such as pension funds and insurance companies to invest only in bonds above a level deemed prudent. Over the years this distinction has become a market convention and serves to define the demarcation between speculative, high-yield, or junk bonds and those considered acceptable for investment. 54 Ratings have a greater role in the investment process than raters publicly acknowledge. Smith has discussed the ways in which knowledge comes to be “objectified” and acquires “authority” in the process of its creation. 55 Her argument is that knowledge, once produced, loses its concrete social origins

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