18.5: Bond Ratings

Question 1

What is DBRS’s rating structure for long-term debt?

Answer 1

• AAA: Highest credit quality
• AA: Superior credit quality
• A: Satisfactory credit quality
• BBB: Adequate credit quality
• BB: Speculative
• B: Highly speculative
• CCC/CC/C: Very highly speculative

Question 2

What is the difference between investment grade and junk bonds?

Answer 2

• Investment grade: Bonds rated BBB or higher, indicating the issuer is likely to meet payment obligations.
• Junk bonds: Bonds rated below BBB, considered speculative and often called “high-yield bonds.”

Question 3

What is the stable rating philosophy?

Answer 3

The idea that ratings are based on structural and not cyclical factors; changes in ratings are not made in response to temporary changes in the economy but only when there are clear structural changes in a company’s credit.

Question 4

What is credit watch?

Answer 4

A status applied to a firm by a rating agency when it is monitoring the firm closely, often due to potential changes in its creditworthiness.

Question 5

What is the hierarchy principle?

Answer 5

A principle based on the fact that rating agencies rate debt issues and not companies; rating agencies rate each class of debt lower than the previous class unless there is little of the higher-ranked debt outstanding.

Question 6

What are the six basic factors DBRS looks at in determining its rating?

Answer 6

1. Core profitability: Standard profit measures such as return on equity, return on assets, growth opportunities, and pricing structure.
2. Asset quality: Importance of intangibles, market value of the firm’s assets, and risk management.
3. Strategy and management strength: Capabilities of senior management in managing credit risk, mergers, and acquisitions.
4. Balance sheet strength: Overall liabilities, debt ratios, coverage tests, and financial flexibility.
5. Business strength: Market share, quality of the workforce, industry issues, and growth prospects.
6. Miscellaneous issues: Quality of financial statements, bond indenture structure, and importance of the firm to the region or country.

Question 7

What is the significance of the bond rating downgrade for CI Financial Corp by DBRS?

Answer 7

DBRS downgraded CI Financial Corp to BBB (high) from A (low) due to concerns about rising debt levels leading to deterioration in financial flexibility, indicated by leverage and fixed-charge coverage ratios.

Question 8

What does the empirical evidence regarding debt ratings by DBRS indicate?

Answer 8

The default rates increase as the DBRS rating goes down, providing a good indicator of credit risk.

The lowest investment-grade rating is BBB, and there is an exponential increase in default rates as credit quality deteriorates.

Question 9

What are seasoned bond issues?

Answer 9

Actively traded bond issues that have been outstanding for some time.

Question 10

What is the significance of bond yield spreads between different ratings?

Answer 10

Bond yield spreads capture the difference between the yield on an index of long-term bonds with similar ratings and the yield on an index of long Canada bonds.

Higher spreads indicate higher default risk and expected recovery rates.