MARKET COMMENT
How Credit Ratings Affect Your Investments

By Stuart Watson (TMFTiger)
February 28, 2003

Many investors are familiar with broker ratings when it comes to looking at their shares. They've received a lot of bad press recently because of factors such as the large number of 'buys' compared to 'sells'.

With company debt levels coming to the forefront of shareholders' minds, another form of rating, namely the company credit rating, has become increasingly important. As the name implies, a credit rating is an opinion on the company's debt rather than its shares. (See this article for more on how corporate bonds work). The main ratings agencies are Standard & Poor's and Moody's (NYSE: MCO).

Standard & Poors is part of McGraw-Hill (NYSE: MHP) while Moody's was split off from Dun & Bradstreet (NYSE: DNB) two and a half years ago. Its shares have doubled since then and Warren Buffett's Berkshire Hathaway (NYSE: BRK.A) is the company's largest shareholder, owning around 16%. Maybe it's just me, but the fact the world's greatest stock picker is invested in a credit rating agency is a little concerning!

Credit analysts are known for being a lot more cynical than equity analysts. They focus far more on cash flow and the ability to repay debt rather than the slightly optimistic profit assumptions you often see in broker reports. So this is why shares move when a credit downgrade (or in better times, an upgrade) is announced. The more suspect a firm's finances, the more sensitive its share price is likely to be to any change in its rating.

Ratings are split into two basic camps. There is investment grade and non-investment grade (known as junk bonds). Investment grade bonds are, as the name implies, more suitable for investment purposes and the chances that your capital will be repaid at the end of the day are high. Junk bonds are much more speculative and there is considerable risk that the company could default on its payments at some point. Slipping from investment grade to junk status is considered far worse than being booted out of the FTSE 100. It's the financial equivalent of being told to stand in the corner of the classroom.

The two main players' credit rating systems are summarised below. The lower down the table you go, the lower the credit rating.

                   Moody's        S&P

Investment grade       Aaa        AAA
                        Aa         AA
                         A          A
                       Baa        BBB

Non-investment grade    Ba         BB
                         B          B
                       Caa        CCC
                        Ca         CC
                         C          R
                        WR       SD/D  

Government debt and large blue-chip organisations usually command Aaa/AAA ratings. However, once you get down to Baa/BBB, the debt issuer is only said to have adequate financial security and may be susceptible to adverse economic conditions. Drop to Caa/CCC and you have very poor financial security with the companies close or vulnerable to default. Slip to C/R and company is typically in default or under regulatory supervision.

The CEO of Moody's, John Rutherfurd, was interviewed in a recent edition of our US site's publication, Stock Advisor. He said that although the percentage of companies being downgraded was typical for this point in the economic cycle, the aggregate value of borrowings far exceeded previous credit cycles, due to the enormous levels of debt taken on by telecom companies in particular. However, a little more encouragingly, he also thinks it's the end of the cycle and growth in credit rating revenues is expected to slow a little in the next few years.

More: Investing Terms Explained