Wednesday, October 20, 2010

The Importance of Being Investment Grade

While references to credit ratings are being removed from statutes and federal regulations (effective July 2012) their position in our existing investment framework remains secure.

We have discussed previously how credit rating downgrades might negatively influence a security's price by decreasing investor demand (some funds and companies, for example, can only buy debt of a certain credit quality) and increasing funding costs (collateral/margin requirements), which may lead to the inevitable vicious cycle.

The deeply embedded nature of ratings in financial contracts is even more apparent when we look at the ramifications of a downgrade on H&R Block's corporate debt (CUSIP 093662AD6), which has been the recent focus of negative attention from the rating agencies. If the debt is downgraded by Moody's to Ba1 or below and/or by S&P to BB+ or below, the coupon on these notes will increase, and the debt will thereby become more expensive to HRB. In other words, if a downgrade is an indication that a company is struggling to meet its obligations, the downgrade in its enactment (by construction) might make said obligations more expensive, which precipitates further difficulty in meeting them. As such, the rating provided is integral to, and certainly not de-linked from, the performance of the security being rated.

These bonds are currently Baa or BBB, investment-grade bonds. However, as the table illustrates, if either rating agency alone downgrades the debt to the Ba1 or BB+ level, the coupon on the bond will increase by 25bps from 7.875% to 8.125%. If both rating agencies downgrade the debt to this level, the result will be a 50bps increase to 8.375%. The interest rate increase is capped at 2%, which will be effectuated if Moody's downgrades the bond to B1 or below and S&P downgrades it to B+ or below.

The (unfortunate) consequence: a downgrade immediately increases the coupon on the bond, which decreases the price. That's in addition to the decreased demand for the bond, the heightened illiquidity, and the increased funding costs for holding the bond. If downgraded, a devaluation of the bond is inevitable, irrespective of the market's opinion of the accuracy of the rating agencies' opinions.


simmons said...

yes we're definitely completely dependent on the raters still. today Assured Guaranty got downgraded from triple AAA to AA+ and their stocks down like 10%. If they get downgraded further it will drop again. Like a self-fulfilling prophecy they can put AGO outa business by downgrading it and then saying "see we were right, they were weak!"

Ron Carleton said...

Great blog post.

Price grids like you describe exist in most corporate loans, but I haven't seen them in corporate bonds. How common are they?

This is just a way to compensate investors for the higher risk of owning the bond as the issuer's credit risk goes up. The fact that the bond has a pricing grid should allow the issuer to get a lower initial spread on the bonds (i.e. investors should accept a lower return since some of their downside is covered by the pricing grid).

Even with the pricing grid, the bond's price will fall if the company is downgraded since market returns on B rated companies are several hundred basis point above BBB rated companies, but the pricing grid only adds 100bp.