From time to time one hears about countries, companies and investing assets being downgraded to “junk status.” This refers to the credit rating of an entity and its ability to meet future obligations. In this article, we discuss credit rating agencies and what junk status means.

Rating agencies

Credit rating agencies exist to provide investors with a sense of the riskiness of an asset. They assign credit ratings to government debt, municipal debt, and corporate debt. Their ratings are concerned with the ability of a debtor to meet its obligations. This does not include equities (shares) but can include preferred shares which are like debt.

Typically, governments will have two ratings: one for debt denominated in the local currency and one for debt denominated in foreign currencies. Other entities will often have a separate rating for each instrument.

Borrowers demand higher yields from riskier assets. So, the credit rating of an asset has a significant effect on the interest debtors need to pay when they borrow.

The largest rating agencies in the world are Moody's Investors Service, Standard & Poor's and Fitch Ratings. These three agencies assign about 95% of all credit ratings around the world.

Investment-grade versus junk grade

Rating agencies have 7 to 10 different grades that they assign to assets. Of these, the top four are considered investment-grade ratings.

The agencies differ slightly regarding what each category means, but the differences are minor. There are also some differences in notation. For example, S&P and Fitch’s top rating is AAA, while Moody’s uses Aaa. Fitch and S&P’s ratings run from A down to D, while Moody’s ends at C.

Investment-grade starts at AAA for the least risky assets. This is followed by AA, A, and BBB as the risk increases. However, assets with all these ratings are regarded as being investable rather than speculative. What this means in plain English is that there is a high probability that you will get your money back.

Junk grades are also known as speculative or non-investment grades. These start at BB and are followed by B, CCC, CC, C, and D.

All these ratings fall under junk grade, but there is a big difference between the top and bottom of the scale. Assets rated BB and B are highly sensitive to the economy but are not in immediate danger of default. Assets rated CCC and CC are only expected to retain any value if conditions or fundamentals improve. C and D are used for assets that are on the brink of default or bankruptcy or already defaulting.

What does junk status mean for an economy?

When a country or a company is downgraded from an investment-grade rating to a junk grade rating there are immediate effects.

For a start, most pension funds and investment products designed for retirement savings are only allowed to be invested in investment-grade instruments. The result is that any of these funds must immediately sell bonds that have been downgraded. This can cause prices to tumble because only certain funds can buy the bonds.

When bond prices fall, their yields rise. So, if a country or company with a junk rating wants to issue new bonds, it will need to pay a higher interest rate on that debt. That immediately puts more pressure on the ability to meet future obligations.

Junk ratings exist to warn investors about the risks of investing in an asset. However, a downgrade to junk status can also increase the risk by raising the cost of debt for an entity.

Junk bonds

Similar consequences face companies when their debt is downgraded. Their ability to borrow more is curtailed, and they must pay higher rates on any new debt they do issue.

Bonds that are rated below investment grade are known as junk bonds or high yield bonds. On the one hand, they offer attractive yields, but they also come with significant risk. Junk bond investors can diversify risk by buying lots of different bonds and sticking to those that are just below investment grade. If a junk bond is upgraded to investment grade, investors can make an immediate profit when the price adjusts to the new rating.

In the case of corporate bonds, junk bond investors will often leverage the fact that bondholders are paid out before shareholders. So, if a company is liquidated, bondholders will have the first claim on the assets.

Junk bondholders also look for companies that are in the middle of a turnaround or restructuring. If the bonds are very cheap, the potential gains may offset the risk of failure. This is known as distressed debt investing.

Credit ratings are far from perfect

Rating agencies were one of the contributing factors during the Global Financial Crisis of 2008. There are two problems with the way the industry works which caused this.

Firstly, SPVs (special purpose vehicles) containing lots of different investments can be given a single credit rating by these agencies. This is highly subjective and can result in an SPV containing junk bonds being AAA-rated if it also contains AAA-rated bonds.

Secondly, the companies that create and sell SPVs pay the agencies to rate them. This creates competition and the agency most likely to give an SPV the highest rating is likely to be hired.

The result was a bubble in SPVs that should have been rated as junk but were instead rated AAA. Investors were happy to pour billions of dollars into products backed by low-quality, subprime mortgages because they were AAA-rated. When these mortgages began to default, the entire industry collapsed, along with several large institutions.

The moral of the story is that investors should always do their homework and never rely entirely on the opinion of someone else. It is, however, worth knowing how a downgrade to junk status can affect investments, companies, and economies.




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