6. Credit rating

Why do rating agencies exist?

As the corporate bond market grew, so did the need to evaluate issuers’ creditworthiness. Today’s major rating agencies were quick to fill that need. The rating agencies have no links with the arrangers or issuing companies and can therefore make an independent evaluation of the credit risk. A credit rating from the major credit agencies incurs a cost for issuers, but at the same time they can benefit from being able to borrow more cheaply than they could without a credit rating.


Rating agencies divide their credit ratings into two main classes: investment grade and high yield. Investment-grade companies have to have a negligible default risk. They have to be one of the market leaders in their sector and have moderate indebtedness so that they can manage a whole business cycle without major problems. AAA is the highest rating and BBB- the lowest rating within investment grade.


Characteristic of a high yield bond is that its default risk is not negligible; rather it exists in varying degrees. High yield spans from BB+ down to C, which is the lowest rating above D (default). The default risk increases the further down the high-yield ratings you go.


The market’s reaction to changes in ratings can vary considerably. In many cases a change in rating is expected by the market, but if the change is unexpected it often has a major impact on the bond’s price. A downgrade from investment grade to high yield often results in a major price change, which can be explained by the fact that different investor groups invest in the different rating segments. A downgrade may trigger forced selling. This is a sale that has to happen for some asset managers to comply with their investment mandates.


The rating agencies’ credit-rating models are partly a trade secret. Nevertheless, there is a lot of information about how the rating process works.

The rating agencies base their credit ratings on both qualitative and quantitative variables. The variables carry about the same weight in the rating process.

The quantitative variables are based on historical accounting data and market variables, while the qualitative variables are based on an evaluation of the business concept and of the management and owners’ experience and expertise.


It has not always been easy for the rating agencies. They were criticized for not seeing the financial crisis coming in Asia in the 1990s. They were caught napping when the major accounting scandals broke in the US (Enron and Worldcom) and they had to pay heavy damages for their input during the 2008 financial crisis. Today many companies choose to issue bonds without an official credit rating for cost reasons and because rating agencies’ work is being called into question.

The Merton model

In the 1970s, Robert C Merton developed a credit model that differed radically from the rating agencies’ process. The Merton model is forward-looking and based on viewing bondholders as issuers (sellers) of a put option on the company’s total asset stock. The bondholders lose nothing as long as the company’s value is greater than the sum of all of its loans. The model is largely based on market variables and uses data from the stock market. Many market participants use the Merton model as a complement to conventional credit analysis. The model works best for listed companies.

Nowadays Moody’s in particular, but also S&P, uses its own models which are based on Merton’s way of thinking. Their ratings are based in part on the results of these models.

Bloomberg, one of the largest system and information providers in the fixed-income market, has also built its own Merton model called the Bloomberg Default Risk Model.


Merton revolutionized credit analysis with his option-based valuation model. The model is completely market-based and is not affected by any rating agency or analyst’s valuation of the company. In 1997, Merton was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for his research in this field.

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