Bond Ratings and Agencies

1. Bond Ratings and Agencies Ford Baertlein D’Anna Piro

2. Introduction to Bond Ratings • Indicator of how much default risk bonds carry • One of the most important factors in bond purchases for potential investors • Agencies assess and report credit worthiness of debt issues so that investors can make informed decisions • Lower informational costs to investors

3. Bond Rating Agencies • Standard and Poor’s • Moody’s Investors Service • Fitch IBCA • The three combined rate 80% of all municipal and corporate bonds • 7 rating agencies have received the Nationally Recognized Statistical Rating Organization Designation • Reputation is important • Purpose is to determine the credit worthiness of companies’ and governments’ debt issues • Customers – corporation, governments, institutional investors, depositors, creditors, investment banks, commercial banks, and other intermediaries

4. History of Standard and Poor’s • 1860 - Henry Varnum Poor’s publication “History of Railroads and Canals in The United States” • 1906 - Standard’s Statistics Bureau created to provide previously unavailable financial information on U.S. companies • 1916 - Standard’s moved into debt ratings • 1940 - Standard’s added municipal bonds to debt rating services • 1941 – Standard’s Statistics and Poor’s Publishing merged • Today – Rate $32 Trillion of outstanding debt in 100 countries

5. History of Moody’s • John Moody - investment entrepreneur with a talent in journalism • 1900 - Published “Moody’s Manual of Industrial and Miscellaneous Securities” • Sold out within 2 months • 1907 - Company did not survive the stock market crash • 1909 - Moody began to offer investors analyses of securities and their investment quality • 1924 - ratings covered the entire U.S. bond market • Survived the Great Depression because very few highly rated companies defaulted • Today - serve over 100 countries, 12,000 corporations, 29,000 public finance issuers, and 96,000 structured finance obligations

6. History of Fitch • Distant 3rd in the industry • 1913 - Fitch Publishing Company was founded by John Knowles Fitch • Began as a financial statistics publisher • 1924 - moved into ratings • Today - employ 2,100 professionals in 49 offices worldwide

7. Industry Wide Changes • 1930’s – Banks began to be assessed on quality and quantity of corporate bonds that they invested in • Used to judge the safety of the bank • 1936 – Regulators placed requirement that banks could not invest in bonds that received ratings lower than investment grade • 1970’s – Credit Rating Agencies began charging issuers • Previously investors were charged for information on the credit worthiness of debt issuers • Technology boom made it easier for people to reproduce and redistribute documents • Decision of the agencies (more sustainable business model) • Companies and municipalities pay to have their bonds rated because investors assume the worst without information

8. NRSRONationally Recognized Statistical Rating Organization Designation • 1975 – NRSRO formed • SEC determined capital requirements for broker dealers for the quality of bonds they could put in their portfolios • Requirements are based on bond ratings • NRSRO was eventually adopted by banks, insurance companies and financial regulators • Now an industry standard that bond ratings do not carry value if they are not rated by a NRSRO company • No formal requirements for NRSRO designation, but the company must be cleared by the SEC • S&P, Moody’s, and Fitch were grandfathered in

9. Ratings – Broken Down • Bond ratings are an assessment of the ability of an issuer to meet its financial obligations in full and on time • Ratings are a combination of computations and subjectivity • Rating professionals are considered insiders • Each credit rating is individualized to the entity and bond issued

11. Bond Rating Criteria • Criteria and methodology used to determine bond ratings varies by company • Generally bond ratings take the following into account: • Economy • Debt Structure • Financial Condition • Demographic Factors • Management • Additional considerations include covenants and protections offered by bond documents

12. Junk Bonds • Also called “speculative” and “high yield” • Below BB+ or Ba1 • Packaged up and included in high yield mutual funds • How did they get their name?

13. Implications • http://finance.yahoo.com/bonds • Par value, non-callable, corporate, maturity range any to 15. • Bond yields and ratings have an inverse relationship • The more risk, the more potential reward the investor will demand • High ratings are important for companies because they imply a lower cost of borrowing • Lower ratings may make bonds less liquid in the secondary market

14. Class Experiment • Bond • Non-callable, corporate bond • 10 year maturity • Par Value • What percent return would you demand?

15. Class Experiment (Cont.) • Now a Bond • Non-callable, corporate bond • 10 year maturity • Par Value • Rated by Moody’s as AA (investment grade, low risk of default) • What percent return would you demand?

16. Class Experiment (Cont.) • With limited information, investors are going to assume the worst • If investors are assuming the worst, they are going to require a higher return • This makes the cost of capital much larger for a company • This is why companies opt to have their bonds rated

17. Criticisms of Bond Rating Agencies • They do not downgrade their bonds fast enough • WorldCom – issued favorable ratings 3 months before bankruptcy • Enron – issued favorable ratings four days before bankruptcy • Mortgage backed securities – showed few signs of insecurity before collapse • Scrutinized for having too strong of relationships with corporations

18. Current Bonds and Ratings • Recently, there has been a conflict of interest between bond raters and bond issuers because of securitization • Bond raters are involved in the issuance of collateralized debt obligations by telling investment banks what needs to happen to get a certain rating • Agencies make money this way • Can we trust a system where raters are paid by the issuers?

19. Summary • 3 main agencies • Histories • Purpose of agencies • Formation of the NRSRO • Ratings • How they are determined • Bond designations • Implications • Criticisms of Agencies

20. Questions?