Comparing Debt Ratings

As we enter the recession accompanied by tight credit markets, we can expect to see a higher rate of default on corporate and some national debt. Understanding debt ratings is important to avoiding some of these train wrecks.

This is harder than it needs to be since there is no agency that rates all potential investments and each debt rating agency uses a different rating scheme.

Debt

Debt ratings are forward looking measures of how likely the debtor is to default on their obligations.  The following table is a handy guide to comparing debt ratings from different agencies. Source: The Bond Market Association

Equivalent Credit Ratings

Credit Risk Moody’s Standard & Poor’s Fitch IBCA Duff & Phelps
INVESTMENT GRADE
Highest quality Aaa AAA AAA AAA
High quality (very strong) Aa AA AA AA
Upper medium grade (strong) A A A A
Medium grade Baa BBB BBB BBB
NOT INVESTMENT
GRADE
Lower medium grade (somewhat
speculative)
Ba BB BB BB
Low grade (speculative) B B B B
Poor quality (may default) Caa CCC CCC CCC
Most speculative Ca CC CC CC
No interest being paid or bankruptcy
petition filed
C C C C
In default C D D D
  1. The ratings from Aa to Ca by Moody’s may be modified by the addition of a 1, 2 or 3 to show relative standing within the category.
  2. The ratings from AA to CC by Standard & Poor’s, Fitch IBCA and Duff & Phelps may be modified by the addition of a plus or minus sign to show relative standing within the category.

Credit

Credit ratings are backward looking measures of revolving debt, open, and installment loans:

Installment Debt – Installment debt is money owed to a creditor who expects repayment over a fixed period of time made in equal monthly amounts. A mortgage or a car loan is an example of installment debt. The debtor is making the same payment over a fixed schedule of time. An auto loan, for example, might call for 48 equal payments of $300. A home loan might call for the same payment of $1000 every month for 30 years. These loans are all paid off in installments.

Revolving Debt – Revolving debt is money owed to a creditor who sets the monthly payment based on the current balance. Credit cards, lines of credit, or retail store cards are examples of revolving credit. Each month the balance of credit available varies based on the debtor’s activity from the previous month and any unpaid amount rolled over or “revolved.”

Open Debt – Open debt is the least common type of debt and means that each month the debtor can run up a balance and is expected to pay it in full when the bill is due. A cell phone is a good example of open debt. The American Express Green Card is another example of open debt. There is no predefined credit limit and the balance must be paid in full each month.

The letter “R” refers to a revolving debt, “I” stands for instalment debt, and “O” stands for open debt. The numbers range from 0 (too new to rate) to 9 (bad debt or placed for collection or bankruptcy.) 

For a revolving debt, an R1 rating is the notation to have. That signifies that the creditor pays their bills within 30 days, or “as agreed.”  Similarly for instalment and open debt, an I1 or O1 rating is top-tier. For example, a 90 day GIC from the Royal Bank of Canada would carry an R1 rating and a 5 year Canada Savings Bond would carry an I1 rating.

FICO

FICO is a standardized method of aggregating credit ratings.  It is widely used in the USA and Canada to establish credit ratings for individuals, but the concepts can be applied to corporations too.

FICO scores are weighted summaries of:

  • 35% Payment History (proportion paid on time, etc)
  • 30% Total Amount Owed (amount owning accross different types of accounts)
  • 15% Length of Credit History (time since accounts opened, time since last activity)
  • 10% New Credit Applied For (number of recently opened accounts and proporation of accouts recently opened by type of credit account)
  • 10% Types of Credit Used (number of credit cards, retail accounts, installment loans, mortgage, consumer finance accounts, etc.)

The resulting FICO score is on a scale of 300 – 900 where a higher score represents higher credit quality and usually results in a lower interest rate for the credit applied for.  For example, a $150 K mortgage with a 30 year term under different FICO scores could range from 5.5 – 7.25% as shown below:

FICO Score  Interest  Payment
760 – 850 5.64% $865
700 – 759 5.86% $886
680 – 699 6.04% $903
660 – 679 6.25% $924
640 – 659 6.68% $966
620 – 639 7.23% $1,021

By law in both Canada and the USA you can get a copy of your own credit rating for free by mail (or immediately via online purchase).  There are two main credit bureaus in Canada: Equifax Canada and TransUnion Canada.

You can also use FICO score calculators to estimate your credit score.

Corporate Rate Spreads

This page by Reuter’s Bond Channel shows the real time view of interest rate spreads over US treasuries (which currently are assumed to be of zero risk).

The page shows how interest rates vary both by time and by quality.

Note the links at the bottom of the page that allow you to toggle between different types of bonds using the Dow Theory categories.

Interest rate spreads are measured using Basis Points, where 1 Basis Point = 1/100 of 1%.  In other words, 100 basis points = 1%.

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2 Comments

  1. chris  •  Jun 20, 2009 @8:43 am

    I found this video on YouTube which really opened my eyes to the importance of getting out of debt: http://www.youtube.com/watch?v=50bWUrKAbwU
    I am sure you will be as amazed as I was.

  2. renaud  •  Jul 15, 2009 @12:06 am

    Indeed amazing. Let’s also not forget that most cash currency is also suspect since it too is just based on government promissary notes and not gold.

    Staying out of debt and holding hard assets (gold, real estate, …) has proven to be the safest course of action over the past several thousand years. Obviously some cash liquidity is necessary, but savings are not really real if they are not actually real. :)

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