Lesson 142018-11-01T07:40:41+00:00

BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE

LESSON 14: WHAT IS THE S&P CREDIT RATING

LESSON 13
COURSE OUTLINE
LESSON 15

LESSON OBJECTIVES

  1. Learn what a credit rating is.
  2. Learn what a credit rating tells you about risk.

LESSON SUMMARY

In this lesson the three major credit rating agencies are first introduced. They are Moody’s, S&P, and Fitch. Each of them has different rating symbols when rating bonds from a company. For example Moody’s highest rating is “Aaa” where S&P uses “AAA” as their highest rating. Overall though the structure if the same for all agencies raking company from the most safe to buy bonds from at the top rating, to companies in default at the very bottom.

In general it can be said that there are two types of rating of bonds. The safer bonds are considered “Investment Grade” while the less safe bonds are considered “Speculative”. When we talk about safe bonds we talk about the risk of the company not being able to meet their debt obligations.

Credit rating can also be useful for the stock investor. When analyzing a stock that you know has debt you might consider looking up the credit rating. That way you get a second opinion on the debt situation. Remember that debt is just as important to the stock investor as the bond investor. If debt obligations cannot be met, the company would go into default and the stock investor’s investment will also be on the line.

The problem about charts saying raking investment is that there are no statistics behind it. For instance how would you rate “Baa”? What does that really mean for me as an investor? For this reason a chart showing how many companies that went into default and matching that with the rating categories. From here it is very clear that as soon as we are down in the “Speculative” categories, one really has to do the research to figure when buying securities for that company. One important take away from the chart is that a municipal bond can be of considerable less safe rating than a corporation, and have the same or smaller risk of default.

For credit ratings in general three pointers are highlighted in the end:

  • You have to make your own research. You can’t rely solely on other peoples opinion.
  • Don’t just look at the rating, you need to understand the numbers behind.
  • In the end, your risk tolerance and knowledge should be the guidance for you personally as investor.

NEW VOCABULARY

Credit Rating Agencies
Credit Rating Agencies: Examples include Moody’s, S&P, and Fitch. These credit agencies rate the safety of bonds, thereby giving investors a second opinion of the risk of the company not being able to meet debt obligations.

LESSON TRANSCRIPT

There are three difference major credit companies – Moody’s, S&P, and Fitch. They basically have the exact same rating scheme. Moody has an Aaa, whereas S&P uses AAA. It’s all the same thing; it’s all the same scale.

As you look at the scale in the video, you can see the top has a prime investment. Meaning, it doesn’t get any better. This is a company that can absolutely repay their debts. At the very bottom as you look down, the lowest is in default. Stay away from that, because that company or government institution is about to go bankrupt; they won’t be able to repay their loans.

When buying a bond, an AAA or Aaa bond has the chances of repaying all coupons and giving the Par value back at the end of the investment. This is very good with the prime investment. The one rated in default is very bad. They most likely cannot pay. Everything in between is something to figure out.

Still basing at the video, as you go down the scale, there’s investment rate and there’s noninvestment rate. Everything above the BBB- or the Baa is considered investment rate, anything below that is noninvestment and understood as being speculative. That’s important to understand. This can work for both bonds and stocks.

When buying stocks and concerned whether a company has debt, go to the corporate page, find the information, check the debts, and look at their bonds. You’ll see what the category is for those bonds that the company has. When the company has a bunch of AAA bonds, in no circumstance will they be in trouble to repay debts, and that’s a good thing. It is important to buy stocks at companies with little or no debt. If they have, they need to have a very high credit rating.

When buying bonds, you can bargain with coming a little bit lower, but that’s all based on the amount of risk that you’re willing to assume.

The meaning of an AA bond is frustrating. How much risk is that? There’s no way to answer without knowing numbers associated with the rating. The charts don’t tell anybody anything, because there’s no statistics behind them. Here are statistics behind it to show what some of these ratings are equal to.

Only Moody and S&P numbers are here. Look at the chart and see the comparison. How many numbers are in default? At the very top of both Moody and S&P, if you had that rating, there’s a 0% chance that you’re going into default. If you’re a corporation, you can see for Moody it was .52% and for S&P it was .60%; that‘s how much the risk is. You could see at a number how much risk-associated the ratings for both of these are.

Remember, the BA or BB bond is whenever things start becoming speculative in noninvestment rate. Look at those numbers and see a drastic change in the number. Something interesting is the corporation number for the BB for Moody. 19.12% of those companies went into default. 20% is really high. When you look at the S&P, they almost had 30%, so S&P has much higher rating compared to Moody. When you look lower, you can see how much higher those numbers go. When you look into the category especially for corporations, 70% for both Moody and S&P is extremely high. When buying bonds that are down there, there’s only about 30% chance you’ll get your money back, which really low.

It’s nice to know the numbers behind these letters, which absolutely has no meaning to anybody for a person who is involved with buying and selling bonds. When you look down there at the numbers for the average, if you’re buying investment rates for corporations with the Moody’s rating, there’s only a 2% chance of failing. For S&P, it’s 4%, which is very significant when you look at how their rating stands.

For noninvestment grade, the numbers go much higher especially for corporation. People will look at an AAA rating for a corporation, but that’s almost the same as getting down there in a BBB. When you are comfortable buying an AAA corporate bond, you should be equally comfortable buying BBB bond, because the numbers are better than the AAA corporate.

When buying bonds, think about the charts and how secure they are as we go into a lower category and rating.

Cumulative Historical Default Rate

Moody’sMoody’sS&PS&P
Rating CategoryMuniCorpMuniCorp
Aaa/AAA0.00%0.52%0.00%0.60%
Aa/AA0.06%0.52%0.00%1.50%
A/A0.03%1.29%0.23%2.91%
Baa/BBB0.13%4.64%0.32%10.29%
Baa/BB2.65%19.12%1.74%29.93%
B/B11.86%43.34%8.48%53.72%
Caa/CCC16.58%69.18%44.81%69.19%
Averages
Investment Grade0.07%2.09%0.20%4.14%
Non-Investment Grade4.29%31.27%7.37%42.35%

What’s important?

  • A public opinion poll is no substation for thought. – Warren Buffett
  • Looking at the letters is pointless. You need to understand the statistics behind the letters. – This gives you a metric for risk.
  • In the end, measure your own tolerance risk and be realistic in what you actually know.

In this lesson, students learned how to read a credit rating score. The most important aspect of reading a credit report is understanding what the letters represent. As we initially looked at the chart, the letters had no meaning. Once we put statistical information to the chart, intelligent investors can then assess the amount of risk associated with their decisions.

One of the key points we learned in this lesson is the difference between municipal bonds and corporate bonds. Although these two securities may have the same credit score, their chance of default is drastically different. For a corporate bond, defaults are much more prevalent compared to municipals. This is something to definitely understand and compare when you begin shopping for great bond picks.