25 years: Treasury & ALM
Investors in a company’s debt rely on the company’s credit rating to determine whether the risk is worth taking. In this video, Moorad explains what a credit rating is, how a formal credit rating is calculated and how it is used to determine the level of risk of holding a particular debt issue.
Investors in a company’s debt rely on the company’s credit rating to determine whether the risk is worth taking. In this video, Moorad explains what a credit rating is, how a formal credit rating is calculated and how it is used to determine the level of risk of holding a particular debt issue.
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6 mins 26 secs
Investors in a company’s debt rely on the company’s credit rating to determine if the risk that such debt represents is one that they would wish to take, in return for the expected reward that holding the debt issue should bring. Hence, having a high credit rating is of great importance to issuers of debt.
Key learning objectives:
Define credit rating
Understand what credit ratings are applied to
Outline the two methods investors employ in measuring credit risk
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A credit rating is a formal opinion given by a rating agency of the credit risk for investors in a particular issue of debt securities.
Credit assessments take time, and also require the specialist skills of credit analysts. However, given it is costly and time-consuming to assess every issuer in every debt market, investors employ two methods when making a decision on the credit risk of debt securities:
When the investor relies on the good name and reputation of the issuer and accepts that the issuer is of such good financial standing that a default on interest and principal payments is highly unlikely. An investor may feel this way about Microsoft or Boeing, for example.
The tradition and reputation behind the Barings name in 1995 had allowed the bank to borrow at Libor or indeed occasionally at sub-Libor interest rates in the money markets, which put it on par with the highest-quality clearing banks in terms of credit rating. However, name recognition needs to be augmented by other methods to reduce the risk of unforeseen events, as happened with Barings.
Credit ratings are provided by specialist agencies. The major credit rating agencies are:
An agency may announce in advance that it is reviewing a particular credit rating, and may go further and state that the review is a precursor to a possible downgrade or upgrade. When an agency announces that an issue is under credit watch, the price of the bonds may trade lower in the market as some investors may sell their holdings.
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