What those Moody’s S&P long-term credit ratings mean

On the Money
From the August 5, 2011 print edition

The Wall Street Journal recently reported that, “Financial markets began taking seriously the prospect of a downgrade of the U.S.’s triple-A credit rating, which it has held for nearly a century.”

In particular, the major ratings companies all warned they might cut the U.S. credit rating.  Standard & Poor’s, in particular, said it may move even if a debt-reduction deal was met and the $14.29 trillion federal debt ceiling was raised.

AAA ratings have meant a virtually risk-free rate of return, especially for government securities.  A lower rating, implying more risk, should be coupled with a higher return to compensate for the increase in risk.

To place credit ratings into perspective, here’s a look at where they came from and what they mean:

More than 100 years ago, after John Moody was wiped out in the 1907 stock market crash, he came back with an idea — an analysis of security values for investors.  Thus was born Moody’s Investors Service, the world’s largest rating agency, which has more than 700 analysts working in 14 countries.

Standard & Poor’s, a division of The McGraw-Hill Cos., was established in 1860 to provide independent insight, analysis and information to the financial community.  Along with Moody’s, Standard & Poor’s is a pre-eminent global provider of independent financial analysis and information.

Moody’s and Standard & Poor’s dominate the U.S. market, where for decades; ratings have been vital tools for issuers and investors.

Ratings are basically tools for differentiating credit quality.  Standard & Poor’s defines a rating as an “opinion on the general creditworthiness of an obligor.”  The rating process includes quantitative, qualitative and legal analysis.

Rating is largely what determines the borrower’s ability to raise money by issuing debt (bonds) on favorable terms.  The actual ratings definitions are as follows.

S&P’s long-term issuer credit ratings       

AAA: Extremely strong capacity to meet its financial commitments.  The highest issuer credit rating assigned by Standard & Poor’s.

AA: Very strong capacity to meet its financial commitments.  It differs from the highest-rated obligors only to a small degree.

A: Strong capacity to meet its financial commitments, but is somewhat more susceptible to changes in circumstances.

BBB: Adequate capacity to meet its financial commitments.  However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to meet its financial commitments.

BB: BB, B, CCC, and CC rating have significant speculative characteristics.  BB is less vulnerable in the near term, but faces major uncertainties.  Adverse conditions could lead to inadequate capacity to meet commitments.

B: More vulnerable than obligors rated BB, but currently has the capacity to meet financial commitments.  Adverse conditions likely would impair the obligor’s capacity or willingness to meet its financial commitments.

CCC: Currently vulnerable and is dependent upon favorable business, financial and economic conditions to meet financial commitments.

CC: Currently highly vulnerable.

C: Currently highly vulnerable obligations and other defined circumstances.

D: Payment default on financial commitments.

Moody’s long-term debt ratings

Moody’s definitions range from Aaa to C, or from golden-edged bonds to those having extremely poor prospects of ever attaining any solid investment standing.  On this scale, any bonds below Ba generally lack characteristics of a desirable investment.  Here they are:

Aaa: Best quality.  Smallest degree of risk.  “Gilt edged.”  Interest payments protected by a large or very stable margin, and principal is secure.

Aa: Of high quality by all standards.  Margins of protection may not be as large as Aaa, or fluctuation of protective elements may be of greater amplitude.

A: Many favorable attributes; upper-medium-grade obligations.  Security considered adequate, but may be susceptible to impairment in the future.

Baa: Medium-grade obligations neither highly protected nor poorly secured.  Security appears adequate at present, but certain protective elements may be unreliable for any great length of time.  Speculative characteristics.

Ba: Judged to have speculative elements; future can’t be considered as well-assured.  The protection of interest and principal payments may be very moderate and not well-safeguarded during good and bad times.

B: Generally lacks characteristics of a desirable investment.  Assurance of interest and principal payments, or of maintenance of other terms of the contract, for a long period of time may be small.

Caa: Of poor standing.  Such issues may be in default, or there may be present elements of danger with respect to principal or interest.

Ca: Speculative in a high degree.  Such issues are often in default or have other marked shortcomings.

C: Extremely poor prospects of ever attaining any real investment standing. Regardless of the letters, credit ratings are always opinions about credit risk.  With the above framework, maybe those opinions may be better understood.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.