Every so often, headlines of a credit rating downgrade will be followed by news of a 10 or 20 percent drop in a stock’s share price. While most long-time investors are familiar with the idea that credit rating upgrades are good and downgrades are bad, they are not all familiar with the nuisances of what credit ratings are and what they mean.
Much like a personal credit score, a company’s credit rating reflects how likely the company is to repay its debt. Typically, this debt is takes the form of corporate bonds.
The “big three” credit rating agencies are Moody’s Corporation MCO, S&P Global Inc SPGI 1.14% and Fitch Ratings. Although each ratings agency has its own unique system, there are parallels.
A full breakdown of the long-term credit ratings of the three agencies is included in the chart below.
Perhaps the most important part of a credit rating for companies and investors is whether or not a company’s debt is rated “investment grade.”
For all three rating agencies, “investment grade” debt is debt rated BBB or higher. If a company’s debt rating falls below BBB, it is considered non-investment grade. You may also have heard non-investment grade bonds referred to as “junk bonds.”
That may seem a bit harsh, but in reality, a downgrade to junk-level can be very bad news for a company. First, that junk label will discourage an entire class of investors who are looking for high-quality bonds.
Second, as credit ratings fall, the interest rates the company has to pay on debt rises. In this respect, a company’s credit rating has a major impact on its overall cost of capital.
A certain type of high-yield investor seeks out junk bonds to buy because of their relatively high yields. Junk bond ETFs like the iShares iBoxx $ High Yid Corp Bond (ETF) HYG 0.06%operate on the idea that there is safety in diversification.
On the other hand, investment grade corporate bond ETFs like iShares IBoxx $ Invest Grade Corp Bd Fd LQD 0.03% contain only corporate bonds rated BBB or higher and are much better choices for risk-averse investors.
Investors who know what corporate credit ratings are, where they come from and what they mean certainly have a leg up when it comes to understanding the financial situation at a particular company. However, it’s…
Click here to continue reading
Want to learn more about how to profit off the stock market? Or maybe you just want to be able to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common Sense. I don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and tradingcommonsense.com is always available on your local internet!
