Credit scores assess a borrower’s creditworthiness and assign a score based on the borrower’s business activities and financial stability. In the United States, there are three major rating agencies: S&P, Moody’s and Fitch.
The credit rating and the return relationship are inversely proportional in nature. A lower credit rating means higher risk and, therefore, higher return, as investors look for the premium to take the risk and vice versa. The credit risk premium is the spread between the US Treasury and other fixed income investments. The majority of defaults are preceded by downgrades in the issuer’s credit rating. As a result, a warning usually precedes most defaults, although by the time the company defaults, the bond’s price has dropped significantly.
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For example, the rating agency may downgrade a bond or loan from BBB to BB due to a decline in debt repayment capacity, for example a deterioration in the coverage rate of interests. This will significantly increase the bond’s yield and its price will drop. In this particular case, the bond will go from an investment grade to a lower grade, which will force many pension funds to sell the bond since some may only be allowed to hold high quality securities; this will put more pressure on the already low price of the bond.
We will now try to see how the rating agencies approach the risk of default in quantitative terms, in terms of the probability of default and the loss given default. The default rate is derived from a combination of probability of default and loss given default. The probability of default (or PD) and loss given default (or LGD) associated with high yield bonds is indeed much higher than that associated with other asset classes. The probability of default is essentially the probability of the issuer defaulting. Loss-given-default assessments are opinions on the expected loss given default on fixed income bonds. They are expressed as a percentage of the principal and accrued interest at the time of default.
During the first 3 quarters of 2013, high yield issuers suffered more downgrades than upgrades. During this period, downgrades represented 54% of Moody’s sub-investment grade stocks. This compares to 48% and 51% in 2011 and 2012, respectively.