Part 2 – Lesson 16
Companies that regularly borrow debt from the public markets are often rated by the large credit rating agencies in the United States, including S&P, Moody’s, and Fitch. These rating agencies analyze the company’s financials, existing leverage levels, competitive positioning, and financial outlook. Based on this analysis, the rating agencies assign a rating with the highest credit ratings awarded to companies with very low probabilities of default and the lowest credit rating given to companies with higher probabilities of default.
These credit ratings are broadly categorized into investment grade debt and non-investment grade debt. Non-investment grade is also referred to as “junk” debt. Many companies that have a non-investment grade rating strive to achieve investment grade since the cost of debt is lower as the credit rating of a company improves.
Moody’s Credit Rating System (Source: Moody’s)
S&P Ratings System (Source: S&P Global)
Investment Grade – under Moody’s, the investment grade ratings range from Aaa at the high-end to Baa3 on the low-end. Under S&P, the investment grade ratings range from AAA at the high-end to BBB on the low-end.
Non-Investment Grade – under Moody’s, the non-investment grade ratings are Ba1 and below. Under S&P, the non-investment grade ratings are BB and below.
In the years following the 2008 financial crisis, Moody’s and S&P came under significant scrutiny and criticism for having rated much of the residential CMBS (collateralized mortgage backed security) instruments and companies exposed to CMBS as investment grade. These high credit ratings turned out to be wildly inaccurate after the collapse of the mortgage market. Moody’s and S&P were criticized for helping to facilitate the financial crisis by giving investors a false sense of comfort with many of these securities.
Despite these erroneous ratings leading up to the 2008 financial crisis, investors still take the S&P and Moody’s ratings seriously when deciding how to price corporate debt.
As we mentioned in Part 2, Lesson 7, the cost of debt that a company will pay on its borrowings is calculated as the interest rate index plus a certain spread. This spread increases as the credit rating decreases. In other words, AAA and Aaa rated companies will have the lowest credit spread and therefore the lowest cost of debt. As the credit rating goes down the scale, lenders feel that they are taking on more risk of default, so they demand to be compensated for that higher risk of default. Once a company moves into non-investment grade territory, the spreads can increase materially.
Let’s assume that Company A has AAA credit rating and therefore can borrow at LIBOR + 150 bps. With 3-month LIBOR around 2%, this would result in 3.5% cost of debt. Company B has a CCC credit rating, so it can borrow at LIBOR + 650 bps. With 3-month LIBOR around 2%, this would result in 8.5% cost of debt.
You can see from this hypothetical example that a company’s credit rating is a significant factor in determining the spread that lenders are willing to offer to corporate borrowers.
Why are credit ratings important to equity investors?
Equity investors and credit investors both share in the risk of the company, but equity investors sit below credit investors in the capital stack, meaning that during a bankruptcy, liquidation, or event of default, credit investors (lenders) will get their money back first before equity investors can receive their capital back.
Therefore, as an equity investor, it is important to understand how the credit markets are viewing the company. If a company has a low credit rating, an equity investor should be aware that there is an increased probability that their equity could be hurt if the company is unable to repay its debts. Highly leveraged companies that end up going bankrupt often end up with equity values of zero.
Credit ratings also help equity investors determine what the anticipated cost of debt will be for the company. Since the amount of free cash flow to equity holders is calculated only after interest expense is paid, it is important to know the current credit rating and if that credit rating could change in the future.
How often do credit ratings change?
Credit ratings can change periodically as Moody’s and S&P evaluate changing developments of the companies it publishes research on. Often, Moody’s and S&P will announce that they are re-evaluating a credit rating in light of a significant corporate action, such as an acquisition, stock buyback, or significant debt capital issuance.
For example, in situations where an acquiring company is taking on a lot of new debt to acquire the target, Moody’s and S&P may decide to re-evaluate their credit rating to see if a ratings downgrade is warranted due to the deterioration in credit metrics. When a ratings downgrade does occur, it does not affect the cost of previously issued debt, but it will increase the cost of debt issued in the future. The increased interest expense that must be paid in the future reduces the cash flow that is available to equity holders.