Must-know: Are credit ratings another bubble in the making?

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What are credit ratings?

Credit ratings are assigned by credit ratings agencies (or CRAs) for debt securities issued by governments, agencies, and corporates. Ratings reflect the opinion of the CRA with respect to the borrower’s ability to meet ongoing interest and principal repayment obligations in a timely manner. There are two kinds of ratings: issuer ratings and facility ratings. Issuer ratings correspond to the credit risk of the issuer, while facility ratings correspond to the credit quality of different debt issues. Both may differ for numerous reasons, including but not limited to seniority of debt, available collateral, guarantees et cetera. In general, the higher the rating, the higher the creditworthiness of the issuer. The issuer’s lower risk also implies that a lower return is payable on the obligation. The reverse is also true.

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The generally acknowledged “big three” CRAs are Standard & Poor’s (or S&P), Moody’s Investors Service (or Moody’s) and Fitch Ratings (or Fitch). The schedule below gives a picture of Standard & Poor’s and Moody’s long-term obligation ratings by relative credit risk of fixed-income obligations with an original maturity of one year or more.

What are ratings upgrades and downgrades?

A debt issue’s initially assigned credit rating may undergo changes due to changes in macro-economic fundamentals, which may affect all firms in the economy or be due to change in issuer-specific factors such as changes in the business environment, which can impact the firm’s ability to fulfill its debt obligations. A ratings upgrade by a CRA would imply that the issuer’s credit profile has improved. A credit rating downgrade would imply the opposite.

For example, on March 7, 2014, Moody’s placed the credit rating of Safeway Inc. (SWY) debt on review for a possible downgrade, after Safeway (SWY) agreed to be acquired in a leveraged buyout (or LBO) by Cerberus Capital Management in a $9 billion transaction. Moody’s believes the transaction will result in significantly higher financial leverage, which will affect the company’s ability to service about $4 billion of rated debt.

This series focuses on the links between ratings actions (upgrades and downgrades) and the overall economy, specifically looking at companies in the S&P 500. The State Street SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index. Apple (AAPL), at 4.85% of the fund’s holdings, is the largest holding in the ETF. The series will also analyze the impact of ratings actions on fixed income ETFs like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).

LQD seeks to match the price and yield performance, before fees and expenses, of the iBoxx $ Liquid Investment Grade Index, which is composed of the U.S.-dollar denominated liquid investment-grade corporate bond market.

HYG seeks to match the price and yield performance, before fees and expenses, of the iBoxx $ Liquid High Yield Index, which is a broad representation of the high-yield corporate bonds market in the United States.

To learn more about credit rating revisions for corporate issuers in the S&P 500 Index (SPY) and the performance of the economy, read on to Part 2 of this series.

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