One of the most important things that investors consider when
investing in fixed income securities is the credit rating of the
instruments. Credit rating is an indicator of the creditworthiness of a
security. There are three rating agencies that are recognized globally -
S&P, Moody's and Fitch. These rating agencies assign ratings to
fixed income securities that are issued by sovereigns, corporate and
financial institutions. The rating methodology is different for each of
these types of issuers.
Within corporate ratings, the criteria for assigning ratings are different for different sectors and different countries. For example, the methodology for rating property development companies in China would be different from that for Europe and India. There are several country specific factors that need to be considered. Rating agencies have different rating methodologies for analyzing credit derivatives such as Asset Based Securities (ABS) and Mortgage Based Securities (MBS).
The rating criteria comprise both qualitative and quantitative factors. Some of the qualitative factors that are considered in corporate credit rating are: market position of a company, scale of operations, brand name, corporate governance, degree of data disclosure, volatility or cyclicality of the sector, revenue visibility, and diversification of operations in terms of geography, business segments, products, and customers. Some of the most common quantitative factors are leverage (debt to EBITDA ratio), gearing (debt to equity ratio), cash to short term debt ratio and interest coverage ratio (EBITDA to interest ratio). There are some credit metrics that consider cash flows such as; i) Cash flow from operation (CFO) to gross debt, ii) Funds flow from operation (FFO) to gross debt, iii) CFO to interest, and iv) CFO to capital expenditure.
It doesn't make sense for investors to just blindly look at ratings while taking their investment decisions. It is worthwhile to understand the factors that are considered to assess the credit quality of a security or the issuer issuing the security. For example, bonds issued by two different companies may have the same ratings but one of the companies may be of better credit quality. If investors are able to distinguish between these two credits, then they would be able to invest in the stronger credit. The rating criteria are published by the rating agencies on their websites. While some of these are available for free, some have to be purchased or they are available for paid subscribers.
Especially, investors should understand the rating methodologies while investing in high yield (HY) bonds. The high yield bonds or junk bonds offer higher yields and are attractive investment opportunities for fixed investment investors. However, unlike investment grade (IG) rated instruments, the credit risks are high and hence, we advise investors to seek advice of financial advisors who have a better understanding of the rating criteria and the credits.
Within corporate ratings, the criteria for assigning ratings are different for different sectors and different countries. For example, the methodology for rating property development companies in China would be different from that for Europe and India. There are several country specific factors that need to be considered. Rating agencies have different rating methodologies for analyzing credit derivatives such as Asset Based Securities (ABS) and Mortgage Based Securities (MBS).
The rating criteria comprise both qualitative and quantitative factors. Some of the qualitative factors that are considered in corporate credit rating are: market position of a company, scale of operations, brand name, corporate governance, degree of data disclosure, volatility or cyclicality of the sector, revenue visibility, and diversification of operations in terms of geography, business segments, products, and customers. Some of the most common quantitative factors are leverage (debt to EBITDA ratio), gearing (debt to equity ratio), cash to short term debt ratio and interest coverage ratio (EBITDA to interest ratio). There are some credit metrics that consider cash flows such as; i) Cash flow from operation (CFO) to gross debt, ii) Funds flow from operation (FFO) to gross debt, iii) CFO to interest, and iv) CFO to capital expenditure.
It doesn't make sense for investors to just blindly look at ratings while taking their investment decisions. It is worthwhile to understand the factors that are considered to assess the credit quality of a security or the issuer issuing the security. For example, bonds issued by two different companies may have the same ratings but one of the companies may be of better credit quality. If investors are able to distinguish between these two credits, then they would be able to invest in the stronger credit. The rating criteria are published by the rating agencies on their websites. While some of these are available for free, some have to be purchased or they are available for paid subscribers.
Especially, investors should understand the rating methodologies while investing in high yield (HY) bonds. The high yield bonds or junk bonds offer higher yields and are attractive investment opportunities for fixed investment investors. However, unlike investment grade (IG) rated instruments, the credit risks are high and hence, we advise investors to seek advice of financial advisors who have a better understanding of the rating criteria and the credits.
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