In investing, risk and return go hand in hand. One of the most common ways to gauge an investment's risk is the issuer's credit rating. But how do you read that string of letters in the prospectus?
Standardization
Financial markets are always looking for ways to standardize things. Derivatives and futures are a good example, but that is a topic for another post. Today the subject is credit ratings.
History
In the mid-19th century, the big problem for large financial institutions was knowing how solvent a given client was, and how likely it was to go bust. That is when specialized firms began to offer credit analysis of companies and individuals.
In essence, they assessed the likelihood that these people or companies would fail to pay their creditors, whether banks or suppliers.
To make credit risk easier to read and compare, they assigned grades that are comparable regardless of industry or company size.
This is every investor's dream. Imagine not having to analyze a bank's balance sheet or ability to pay to know its credit risk. Looking only at the grade assigned by a rating agency makes the investor's job much simpler.
The main rating agencies
These specialized credit analysis firms evolved into what we now call credit rating agencies. The largest today are Moody's, Standard & Poor's and Fitch, not necessarily in that order. Known as the "Big Three", they are the best-known and most trusted rating agencies and dominate this market worldwide.
Conflict of interest
It is not all good news. The main criticism of rating agencies is that the party paying for the credit assessment is usually the bank or bond issuer itself. The client hires the agency to rate its own credit risk.
That is a significant conflict of interest. The institution that hires the agency wants to show the market a high rating, one that says its risk of not paying creditors is very low.
Picture the client's reaction if the agency gives it a poor rating. An agency that only hands out low grades probably will not last long, because few institutions concerned about their rating will hire it again.
On the other hand, an agency that is too lenient, giving good grades even to poor payers, will not keep a good reputation. Few will trust its ratings, and it will not last long either.
Rating agencies live with this dilemma every day. They say they are as impartial and rigorous as possible, despite the conflict of interest built into the supplier-client relationship.
How does the rating process work?
Each agency has its own methodology for analyzing credit. Some publish it on their website; others do not.
What they all share is a review of the company's finances as a whole. Earnings, cash flow, the market it operates in and its influence in the industry are some of the points assessed. These factors are weighted and fed into a model, or, put simply, a mathematical formula that produces the result: the rating.
Credit rating equivalence
The agencies do not agree on every grade, but it is possible to map the ratings of the main agencies against each other. Below is the equivalence between the three main agencies, split into investment grade and speculative grade ("junk").
| Moody's (long term) | S&P (long term) | Fitch (long term) | Meaning |
|---|---|---|---|
| Aaa | AAA | AAA | Prime |
| Aa1 | AA+ | AA+ | High grade |
| Aa2 | AA | AA | |
| Aa3 | AA- | AA- | |
| A1 | A+ | A+ | Upper medium grade |
| A2 | A | A | |
| A3 | A- | A- | |
| Baa1 | BBB+ | BBB+ | Lower medium grade |
| Baa2 | BBB | BBB | |
| Baa3 | BBB- | BBB- | |
| Ba1 | BB+ | BB+ | Non-investment grade speculative |
| Ba2 | BB | BB | |
| Ba3 | BB- | BB- | |
| B1 | B+ | B+ | Highly speculative |
| B2 | B | B | |
| B3 | B- | B- | |
| Caa1 | CCC+ | CCC | Substantial risk |
| Caa2 | CCC | Extremely speculative | |
| Caa3 | CCC- | In default with little prospect of recovery | |
| Ca | CC | ||
| C | |||
| C | D | DDD | In default |
| / | DD | ||
| / | D |
Investment grade or speculative grade
Investment grade covers companies and institutions with a low risk of default. They are the top of the class.
Speculative grade covers companies and institutions with a higher risk of default. Because the risk is higher, you can expect them to pay their creditors more.
The investment grade versus speculative grade split is widely used in the investment fund industry.
Funds with a bigger appetite for risk, which aim to deliver higher returns to their shareholders, usually invest in bonds from speculative-grade companies and institutions. These are often called "high yield": high return, but high risk too.
Funds with less appetite for risk look for bonds from investment-grade companies, which usually pay less but carry less risk.
Conclusion
Next time you invest in a CDB (a Brazilian bank certificate of deposit), a debênture (a Brazilian corporate bond) or any other bond, look up the issuer's rating and compare each one's return with its risk. Rating and return are closely linked, but I can assure you that you will find bonds with the same rating paying more or less than others, and even bonds with a better rating paying more than bonds with a worse one.