What’s in A(AA) Credit Rating? -Liberty Street Economics
Liberty Street Economics

« The Evolving Market for U.S. Sovereign Credit Risk | Main | How Does Information Affect Liquidity in Over-the-Counter Markets? »

January 08, 2020

What’s in A(AA) Credit Rating?



Update: Clarifying text regarding the net leverage chart, as well as an additional chart, have been added to the bottom of this post. (January 10, 10:40 a.m.)

What’s in A(AA) Credit Rating?

Rising nonfinancial corporate business leverage, especially for riskier “high-yield” firms, has recently received increased public and supervisory scrutiny. For example, the Federal Reserve’s May 2019 Financial Stability Report notes that “growth in business debt has outpaced GDP for the past 10 years, with the most rapid growth in debt over recent years concentrated among the riskiest firms.” At the upper end of the credit spectrum, “investment-grade” firms have also increased their borrowing, while the number of higher-rated firms has decreased. In fact, there are currently only two U.S. companies rated AAA: Johnson & Johnson and Microsoft. In this post, we examine recent trends in the issuance of investment-grade corporate bonds and argue that the combination of increased BAA issuance and virtually nonexistent AAA issuance both reduces the usefulness of the BAA–AAA spread as a credit risk indicator and poses a financial stability concern.

Credit Ratings 101
Credit ratings help investors differentiate between bonds with higher credit risk—those assigned a lower credit rating—and lower credit risk—those with a higher credit rating. Because investors are compensated for holding credit risk, higher-rated bonds earn a lower yield. The top of the credit rating spectrum, so-called investment-grade bonds, is bracketed by AAA—the safest credit rating—at one end and BAA (on the Moody’s rating scale) or BBB (on the S&P rating scale, equivalently) at the other. Throughout this post, we refer both to bonds rated BAA by Moody’s and those rated BBB by S&P as having a BAA rating.

The difference between the yield on AAA-rated bonds and the yield on BAA-rated bonds with similar maturities issued by firms with similar characteristics captures the willingness of investors to hold exposure to corporate credit risk. All else equal, a wider BAA–AAA spread indicates a diminished willingness of investors to bear credit risk. In the lead-up to recessions, investors reallocate their portfolios toward safer securities, as they become more concerned about holding credit risk. As a result, the BAA–AAA spread increases in the lead-up to recessions (see chart below), making the spread a useful indicator of the health of the economy.


What’s in A(AA) Credit Rating?


The Changing Investment-Grade Landscape
To understand whether the BAA–AAA spread is as informative today about the state of the economy as it was when more companies were rated AAA, we need to examine how corporate bond issuance has evolved over time. The chart below plots the total offering amount, over time, of bonds issued with credit ratings of AAA; investment-grade, excluding AAA and BAA; BAA; and high-yield. The chart shows that, while high-yield issuance has been declining since 2012, investment-grade issuance has been increasing, with BAA issuance matching or exceeding high-yield issuance in every quarter since the fourth quarter of 2016.


What’s in A(AA) Credit Rating?


The next chart shows that the increases in BAA issuance occurred across industry groups. Thus, while all of the corporate AAA issuance is concentrated in just two firms, BAA issuance is more widespread, creating a potential mismatch in issuer characteristics between AAA bonds and BAA bonds.


What’s in A(AA) Credit Rating?


Moreover, the next chart shows that while the average maturity of BAA bonds has been increasing over time, the maturity of AAA bonds has remained relatively stable. Thus, not only are the issuers of AAA bonds no longer comparable to the issuers of BAA bonds, but the average maturity of BAA bonds is far greater than the average maturity of AAA bonds, with the disparity in maturity growing over time. That is, the AAA yield represents the market perceptions of the short-term credit risk of two companies, while the BAA yield captures market perceptions of medium-term credit risk of industrial and financial companies more broadly, potentially making the two yields noncomparable.


What’s in A(AA) Credit Rating?


Implications for Financial Stability
Does increased BAA issuance pose a concern beyond making the BAA yield noncomparable to the AAA yield? One way of answering this question is to look at net leverage—the ratio between a firm’s total debt, less cash and short-term investments, and a firm’s EBITDA—by credit rating category. The chart below shows that, while in the late 1990s through early 2000s the average net leverage of BAA firms was lower than that of high-yield firms, in recent years the net leverage of BAA firms has been similar to that of high-yield firms. Moreover, the net leverage of higher-rated investment-grade firms has exceeded the net leverage of high-yield firms since 2003. Thus, on a net leverage basis, investment-grade firms are currently as risky as, if not riskier than, lower-rated firms.


What’s in A(AA) Credit Rating?


Moreover, recent academic literature has documented that insurance companies divest from bonds that have been downgraded to high-yield. So bonds that are already declining in price because of a deteriorating credit outlook can face further stress from the associated selling pressure. In the current corporate debt landscape, with a greater amount outstanding of BAA-rated corporate debt and higher net leverage of investment-grade debt overall, the possibility of a large volume of corporate bond downgrades poses a financial stability concern.

Conclusion
With $9.2 trillion outstanding as of the end of 2018, the size of the corporate bond market in the U.S. rivals that of the mortgage-backed securities market. In this post, we argue that, although much of the post-crisis issuance has been in the investment-grade segment of the market, the large volume of issuance with a BAA credit rating may pose a financial stability concern. Moreover, the maturity and firm-characteristic mismatch between bonds with AAA and BAA ratings reduces the usefulness of the BAA–AAA spread as an indicator of investors’ aversion to credit risk.


Authors' note: The net leverage chart included in the post (above) plots the average net leverage for all firms in our sample, reflecting our focus on the overall corporate sector’s bond issuance. If we, instead, restrict to industrial firms only, the picture is somewhat different, as shown in the chart below, with higher-rated industrial firms having lower net leverage than lower-rated industrial firms.


What’s in A(AA) Credit Rating?



Nina BoyarchenkoNina Boyarchenko is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.



Or ShacharOr Shachar is an economist in the Bank’s Research and Statistics Group.



How to cite this post:
Nina Boyarchenko and Or Shachar, “What’s in A(AA) Credit Rating?,” Federal Reserve Bank of New York Liberty Street Economics, January 8, 2020, https://libertystreeteconomics.newyorkfed.org/2020/01/whats-in-aaa-credit-rating.html.



Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Posted by Blog Author at 07:00:00 AM in Credit, Fire Sale
Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

About the Blog
Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.


Economic Research Tracker

Liberty Street Economics is now available on the iPhone® and iPad® and can be customized by economic research topic or economist.


Most Viewed

Last 12 Months
Useful Links
Comment Guidelines
We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:
Please be brief: Comments are limited to 1500 characters.
Please be quick: Comments submitted after COB on Friday will not be published until Monday morning.
Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.
Please be on-topic and patient: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post. We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will not be posted.‎
Disclosure Policy
The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.
Archives