12^th January, 2021 by elmads

Have you ever applied for a credit card or a loan in the bank before? Where you accepted or rejected? Congratulations if you were approved, but if not, you might need to check how you manage your money or find a stable work that will grant you regular cash flow. Applying for a loan to finance a specific endeavour is hard, most especially when we are asking for a large amount of money from the banks. This is because banks want to make sure that the money they lend will be paid back to them. Just like with us individuals, we always want to make sure that whoever owes us money will return the exact amount of money they owe to us.

Banks mitigate the risk of losing money through a detailed and rigorous financial assessment to the person or company applying for debt. That is why banks ask a lot of requirements to the people who want to take on debt. To give you context on an individual level, surely you would not give a loan to a person that still owes you debt that he/she has not paid yet. You’ll prefer someone who pays the debt in time and has a steady source of income in order to repay that debt.  

These steps are also taken by large institutions when they apply for debt. They also go into banks and undergo the process of an intricate financial assessment. The banks will review the institutions nature of their business, the stability of their income stream, the ability to repay interest payments and the management. I have explained this further on my blog titled “Bonds Asset Class”. Once the banks approve the debt, they will then turn it into a bond which signifies that the Institution (AKA the issuer), will have the obligation to pay coupon payments to the investor who owns the bond. It does not stop there, the banks upon giving the required amount of money to the institution who applied for the debt, will then be categorize it based on the bank’s assessment of the institution’s financial status. This is where credit rating comes in place.

Credit ratings represent the safeness or riskiness of the debt. In particular, think of 5 of your closest friends in your life, what if those 5 friends of yours asked you for money and said that they will repay it after a month. Who do you think will most likely keep their promise, and pay you back based on their financial status and personality? Rate each one of them from 1-5, 5 being the safest while 1 the least safe. This example is just like the credit ratings, it has been made to have a benchmark for each and every debt that has been taken by both the governments and companies. 

The big three Credit rating Companies

There are various credit rating companies in the world, the most popular are the so called “big three”, namely Moody’s, Standard & Poor’s and the Fitch Group. The three of them have one purpose and that is to provide a rating system to aid investors to determine the creditworthiness of a government and company.  

Down below is the credit ratings chart of each of the big three. 

As the chart shows, the ratings have different corresponding letters and numbers depending in the rating company you look into, but generally they have the same representation with other rating company. For instance, Aaa rating of Moody’s is the same for the AAA of S&P and Fitch. What we must understand here is the corresponding meaning of each and every rating. The safest ratings will start from the top while the riskiest will be down the bottom.  

Moreover, Short-term credit rating tackles the chance in which the borrower will default within the year, while the Long-term credit rating is the likelihood that the borrower will default in the extended future which is more than 1 year.

Nevertheless, the chart is still very confusing to understand because of the various letters it has and it does not give any clarity at all. To make it simple for us to understand it, we must take note and remember two terms of credit risk. These are Investment Grade and Non-Investment Grade. 

Investment Grade – These are debts that are considered safe investments. The companies and governments who issued the debt instrument will less likely to default into their coupon and principal payment obligations. Credit ratings from Moody’s Aaa to Baa3 or Standard & Poor’s and Fitch’s AAA to BBB-, are regarded as investment grade debts. The coupon yields with investment grade bonds have usually low or equal return when compared to the average inflation rate.  

Non-Investment Grade – Also known as junk bonds or high yielding bonds. These debts are risky low-quality investments, because the issuers of the debt have a high chance of defaulting into their payment obligations, hence the term junk. The upside of investing in such debt instrument, is the high coupon rates compared to its investment grade counterpart. The high returns are a means to compensate the riskiness of these type of bonds. Credit ratings from Moody’s Ba1 and below or Standard & Poor’s and Fitch’s BB+ and below, are regarded as non-investment grade debts. 

Stocks and credit ratings

This method in credit ratings are not only applicable for bond investing, but it can also be used for stock market investing. Say you are looking into purchasing a stock of a company, one of the metrics that are being checked in analyzing a company are its debts. By going into the company webpage, we can look into their debt and see its credit rating, or we can just directly search it via the internet search engine. So, if a company is high above the credit rating specifically at the A levels then it signifies that they will be able to repay their debts, while the opposite can be said for companies having less than B level ratings. Having a company with high credit rating, low debt amount and manageable debt are what we are looking for to invest in. 

That being said, both investment grade and non-investment grade credit ratings are still vague, in the sense that it does not quantify the safeness or riskiness of the debt. Both of their descriptions are still subjective in nature. It does not state if the S&P’s AAA bonds are 100%, 95% or 90% safe, or if the CCC+ bonds are 20% safe. I did further research about it and I was able to find a good quantifier for this. Below is another chart that shows the statistics for the historical default rates (in percentage) with its corresponding credit rating.  

The above chart is based in the US and may not be applicable in your country. This should not be taken as the basis of our investment but just a guide and reference.  

As depicted in the chart, it indicates the percentage chance of an institution to default on their debt obligations. If we look into per column of the chart based on the credit ratings, it is clear that corporations have higher default rates compared to municipal bonds in a wide margin. In particular, the Aaa/AAA of Municipal has 0% chance of default, whereas corporation is at 0.52%. It is evident that as we go lower into the chart, the higher the chance of both municipalities and companies to go into default with their debt obligations.  

Furthermore, Moody’s credit ratings seem to be on the conservative side because the average default rates are lower compared to S&P’s credit ratings. Fitch ratings are not included because I cannot find a chart with their assessment of default rates based on their ratings.  

To sum it up 

Credit risks in investing are mitigated through quantifying the amount of risk that these bonds possess. Nevertheless, we must always take all information with a grain of salt because these ratings have also its short comings. Just like what happened during the 2008 financial crisis, the rating agencies including the big 3 were not able to see the problem within the mortgage bond securities, which is one of the contributors that kick started the recession. In the end, we must find and follow our own investing strategies, risk tolerance and be realistic in what we actually know about the investment vehicle that we are taking. Outcomes either wrong or correct, will always be the by product of our own decisions. 

Blog update as per 11/04/2021

As I was continuing in doing my research and learnings regarding valuations and risk free rates. I encountered the online class of Professor Aswath Damodaran (a Professor of Finance at the Stern School of Business at New York University, he teaches corporate finance and equity valuation) in which he showed the default spreads of country’s government bonds.

As I have discussed in this blog, one of the safest government bond in the world that has been rated AA+ by S&P and Aaa by Moody’s is the US government/treasury bonds. This means there is no chance of default for the interest payment and par value to be returned when we hold US government bonds.

Unfortunately, not all governments around the world have the ability to pay back their debt. There are default risks and that percentage of a specific government of a country to default with their debts are based again on the credit ratings of S&P and Moody’s. Below is the updated Wikipedia link for each country’s credit ratings.

“en.wikipedia.org/wiki/List_of_countries_by_credit_rating”

The percentage chance of default depending on the specific credit ratings of both S&P and Moody’s can be seen on the chart below.

Credits to the owner: Professor Aswath Damodaran

In conjuction, the steps we must undertake is to know what country we are looking into, then look for the credit rating score by either Moody’s or S&P, then look into the chart above what will be the corresponding default rate.

I’ll be using the Philippines as an example:

As per Wikipedia, the Philippine’s credit rating score as per S&P and Moody’s are BBB+ and Baa2, respectively. That translates to 1.41% default rate if we base it from the S&P and 1.68% if we base it from Moody’s.

That being said, The Philippine’s government bonds is still considered an investment grade bond based from their credit ratings agency.

Let’s continue to grow and learn everyone. Let’s do this!!!

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.