Thomas R. Atkinson

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: Trends in Corporate Bond Quality
Volume Author/Editor: Thomas R. Atkinson, assisted by Elizabeth T. Simpson
Volume Publisher: UMI
Volume ISBN: 0-870-14148-1
Volume URL: http://www.nber.org/books/atki67-1
Publication Date: 1967
Chapter Title: AGENCY RATINGS
Chapter Author: Thomas R. Atkinson
Chapter URL: http://www.nber.org/chapters/c1504
Chapter pages in book: (p. 50 - 57)w
Iv
AGENCY RATINGS
Corporate bonds have been rated by one or more private agencies since
1909. Even direct offerings are currently rated, so that agency ratings
essentially cover all corporate bonds.
The ratings ordinarily attempt to rank issues according to risk of
default, although this intent is not specifically stated in the current
explanation by the principal agencies. One agency refers to the attempt
to grade bonds by their "relative investment quality" in the foreseeable
future without regard to current or future price or yield.1 The other
is even less direct, stating that its ratings are a "simple measure of basic
investment quality." It implies that although earning power is the
most important criterion of analysis, as it "measures the obligor's ability
to accumulate funds to pay principal and interest," 2itis default risk
that is being measured.
The rating agencies indicate that they do not assign ratings merely
on the basis of statistical analysis. In general, according to the agencies
currently compiling ratings, the first two grades (Aaa and Aa or AAA
and AA)high-grade bonds with neither present default risk nor
foreseeable susceptibility to this kind of risk in the future. The next
two grades (A and Baa or A and BBB) are considered to have some
speculative characteristics in the way of possible future lack of earnings
protection, but for the present are considered secure in interest and
principal payments. Bonds in the Ba or BB category (fifth grade) are
those which have little future assurance and only minor investment
characteristics. Bonds below these five grades are speculative in char-
acter in that there can be no assurance of payment of interest or
dividends. Normally, the rating agencies do not rate issues of finance
companies or real estate companies whose underlying assets they are
unable to evaluate.
1Moody'sInvestors Service, Moody's Industrial Manual, New York, 1964, pp. V—VT.
2Standard& Poor's Corporation, Standard Corporation Descriptions, New York,
Vol. 26, No. 3, Section 4, January 29, 1965, pp. 2—3.Agency Ratings 51
Hickman has demonstrated that the record of the agencies in rating
bonds at offering was remarkably good from 1900 to 1943, in that
highly rated issues suffered a much smaller incidence of default than
did lower-rated issues. For example, for all large issues offered during
the period 1900—43, only 11 per cent of the dollar volume rated as of
"investment quality" (i.e., in the first four grades) went to default in
those years in contrast with 42 per cent of the volume rated as "pre-
dominantly speculative." 8
Sincethe postwar period lacks ex post measures, agency ratings pro.
vide perhaps. the most significant indication of bond quality, even
though cx ante, because they represent an assessment of many different
variables affecting risk. While they cannot be taken as perfect sub-
stitutes for an economic test sufficient to produce a noticeable number
of defaults, they are one of the better measures of quality currently
available. Moody's ratings have been used in this study. Essentially,
they rate the same sample of bonds, as Standard & Poor's, principally
publicly offered issues of major corporations.
It would be incomplete to leave the topic of casualty rates among
bonds classified by different agency ratings without indicating one of
Hickman's findings which has been subject to later reinterpretation.
Hickman found that actual loss rates did not completely eliminate the
higher yields accorded bonds with lower agency ratings. Loss rates
were actually negative in the first four agency rating grades (indicating
a gain) and only in grades V—IX was the realized yield lower than the
promised yield by reason of losses.4 Frame and Mills, and later Frame
alone, restudied the problem whether agency ratings are a substitute
for the ultimate indicator of quality, i.e., dollar losses.5 They elimi-
nated call premiums obtained on better-quality bonds that did not
default and high terminal prices for bonds still outstanding at the
end of Hickman's period because it was one of low interest rates.
Their modified loss rates were found to increase directly with a reduc-
tion in agency rating.°
3SeeW. Braddock Hickman, Corporate Bond Quality and investor Experience,
Princeton for NBER, 1958, Table 38, p. 176.
4 ibid., Table 1, p. 10.
5HaroldG. Frame and Robert H. Mills, "Effect of Defaults and Credit Deteriora-
tion on Yields of Corporate Bonds," Journal of Finance, September 1961, and Frame,
Valuation of Securities Holdings of Life Insurance Companies, Homewood, Ill., 1962.
6 Frame, Valuation of Securities, p. 48.52 Trendsin Corporate Bond Quality
Publicly Offered Bonds
In the period 1944—65, 93.5 •per cent of all rated publicly offered
straight bonds were placed in the first four rating grades. This figure,
of course, excludes finance, real estate, and similar bonds; also the
1 per cent not rated. The addition of serial bonds to this tabulation
does not alter essentially the finding that only 6.5 per cent in dollar
terms was rated below the first four grades.
How does this finding compare with the prewar period? Tabulation
of, the Hickman data from 1909, when rating grades commenced,
through 1943 indicates that 83 per cent of rated public offerings in
that period were placed in the first four rating grades. For public offer-
ings, therefore, the postwar quality as indicated by agency ratings was
apparently better than the quality of prewar bonds as shown by this
measure.
The distribution of public offerings by agency rating grades was
covered earlier in the comparison of public and direct placements.
The percentage of publicly offered bonds rated below the first four
rating grades is given in Table 15.
"Investment Grade" Ratings of All Corporate Bonds
An over-all judgment of trends in bond quality requires a consistent
measure or indicator of quality that applies to direct placements and
public offerings alike. Lacking this, the analysis will be subject to
speculation that shifts of bond financing from public to direct offerings,
or vice versa, obscure what is happening to credit quality. Although
it has not been possible to solve the problem of quality comparisons
of two unlike types of bonds, it is possible to make a comparison in
terms of two broad classes, investment grade and subinvestment grade
bonds.
As indicated earlier, over the years there has developed a convention
that certain bonds possess investment, as distinct from speculative,
characteristics. For example, in 1949, the three federal bank examina-
tion agencies with a committee of the National Association of Super-
visors of State Banks issued a statement of examination procedure,
followed since 1938, which describes those bonds achieving favored
treatment for valuation purposes: "Group I securities are marketable
obligations in which the investment characteristics are not distinctly— _—
AgencyRatings 53
TABLE 22
Percentage Distribution of Public Offerings and Direct Placements of
Corporate Bonds Among Agency Ratings, Four-Year Periods, 1908-65
Period ofInvestment
Subinvestment Grade
NoTotal Par Amount Per CentPer Cent
Offerings Grade of Totalof RatedRating(million dollars)
1908-11 24.8 6.0 19.5 69.2 4,808.8
1912-15 45.5 11.0 19.5 43.5 4,942.7
1916-19 65.9 14.0 17.5 20.1 4,552:7
1920-23 79.3 17.7 18.2 3.0 7,911.0
1924-27 81.7 17.1 17.3 1.2 11,011.0
1928-31 77.8 18.8 19.5 3.4 9,963.1
1932-35 72.6 20.6 22.1 6.8 4,214.2
1936-39 85.3 11.4 11.8 3.3 9,400.9
1940-43 88.8 8.6 11.1 22.6 6,128.8
1944-47 96.4 2.3 2.3 1.3 13,975.8
1948-51 96.0 1.3 1.3 2.7 15,822.6
1952-55 95.3 2.6 2.7 2.1 22,296.9
1956-59 89.8 5.2 5.5 5.0 27,269.4
1960-63 91.9 4.4 4.6 3.7 27,653.8
86.4 9.0 9.4 4.5 16,107.9
Source:1908-43, Hickman, Corporate Bond Quality andinvestor
Experience, Table 28, p. 153; 1944-65, Tables B-I, B-2, and B-3 of
this study.
aTWOyears only
or predominantly speculative. This group includes general market
obligations in the four highest grades and unrated securities of equiva-
lent value." A similar determination of "investment grade" for insur-
ance companies has existed since the early 1930's through ratings
published by the National Association of Insurance Commissioners,
although standards in terms of published rating grades have changed;
only since 1951 has the favored classification been equated to the first
four rating grades.
If one can conclude that the intent of the N.A.I.C. ratings was to
designate "investment grade" obligations in selecting those securities
7FederalReserveBulletin,July 1949, p. 777.54 Trends in Corporate Bond Quality
eligible for prime treatment in valuation method, it is possible to com-
bine public and private offerings to obtain the percentage distribution
of bonds considered investment grade and below investment grade by
one or another of the rating agencies.8 Using this definition, Table 22
shows that since the 1920'sapproximately 97 per cent of all corporate
bonds have been rated, and that the percentage rated subinvestment
grade fell through the beginning of the postwar period and has not
varied greatly since then except for a sharp increase in the last two
years. At the time of this writing, it is not possible to interpret the
increase with any assurance of accuracy.
Cyclical Aspects
Hickman's analysis of the cyclical characteristics of bonds by agency
ratings was made largely in terms of the net upgrading and down-
grading of outstanding issues. He found that rating agencies tended to
upgrade issues in the expansion phase of the business cycle and down-
grade them during contractions. Our findings indicate what types of
offerings are associated with different cyclical phases, but do not
describe the behavior of rating agencies themselves during the cycle.
The problem is, of course, that during the cycle not only may the
character of bond offerings change with respect to their quality but
also those analysts judging the quality of given bond issues may be-
come more lenient or less lenient depending on their view of the
business conditions that are likely to prevail over the life of the bond.
The rating agencies indicate that ratings of a given issue should not
be conditioned by the stage of the business cycle, but it may not be
possible to prevent changes in the thinking of those who judge quality
according to the business cycle.
Short of submission of a series of "sample standard" bond issues to
the analysts of rating agencies over several business cycles, there is no
way to determine how much the change in ratings is a psychological
8Thisanalysis, of course, ignores an unknown but obviously small volume of bonds
directly placed between 1945 and 1950 which were rated as "investment grade," i.e.,
eligible for preferred valuation treatment even though equivalent to public offerings
rated in the fifth agency rating class (Ba or BB).
OThelarge proportion not rated in 1940-43 would probably have been reduced
to that of other periods since 1920 if N.A.I.C. ratings had been used for direct
offerings.Agency Ratings 55
one and how much is due to a change in objective facts as these offer-
ings reach the market at various points in the business cycle. The
problem is further complicated by lack of clarity on what might be
expected to happen to objective quality factors over the successive
stages of the cycle. On the one hand, as an expansion progresses it
might be reasoned that firms would show a stronger financial position;
conversely, in a recession, they might show financial deterioration and
therefore their bonds might be judged poorer risks. On the other hand,
the nature of business expansion is to offer hope of success to enter-
prises that might not succeed except in boom periods. Similarly, in-
vestors may be receptive to poor bonds in expansion periods but be
wary of them in recessions. This might cause bond offerings of rela-
tively poor quality to be brought forth during expansions, with the
opposite occurring during recessions.
Chart 7 shows that, in the first two business cycle expansions of the
postwar period, a smaller proportion of offerings at the peak were
rated subinvestment grade than at the previous trough. In the later
CHART 7
Percentage of Rated Bond Offerings in Sub investment Grade, 1944—65 a
Source: Tables B-i, B-2, and B-3.
Note: Shaded areas represent business contractions;
aIncludespublic offerings and direct placements of
unshaded areas, expansions.
straight and serial bonds.
Per cent56 Trends in Corporate Bond Quality
two recoveries (1954—57 and 1958—60) the opposite was the case. Pre-
cisely the opposite behavior was characteristic of the recession periods
(eliminating 1944—46). The facts are consistent with the hypothesis that
until 1954 the quality of bond offerings was primarily a function of the
financial standing of companies, but that after 1954 quality varied
inversely with presumed prospects, the greatest change taking place
in the period following 1962.
Another facet of the problem should be considered. Less than 12
per cent of offerings (by value) received a subinvestment grade rating
in any year of the period 1944—65; hence the division into two groups
may be too gross to show adequately the sensitivity to business cycles.
More marked cyclical conformity might appear in the proportion in
a larger class, such as the third grade or below.
Following this approach, the data on postwar cyclical swings in
agency ratings are shown in Chart 8 only for public offerings of straight
bonds, since the agency ratings on direct placements (N.A.I.C.) do not
make a fine enough distinction for private offerings. The bottom curve
represents what previously has been called "subinvestment grade"
(grade V and below), but it differs slightly from Chart 7 because of
differences in underlying data. The next higher curve represents grade
IV and below, and so on. The spaces between the curves represent
individual rating grades.
For public offerings of straight bonds, the class grade V and below
has comprised from less than 1 to 21 per cent of rated public offerings
in various postwar years. If only the first three grades are considered
"investment grade," then "subinvestment grade" (grade IV and below)
has represented 5 to 37 per cent. That curve rises in four of the five
contractions. The same is true of grade II and below, while the inter-
mediate curve (grade III and below) rises in only three contractions.
The chart is hard to interpret, but it does show clearly the following
three points:
1. The proportion of prime bonds (grade I—Aaa) increased from a
low point (5 per cent) in 1952,10 but since the early 1960's has been
shrinking.
toThisis exaggerated in 1960—63bythe upgrading of American Telephone and
Telegraph bonds. If new offerings by that company had been rated only Aa in
1960—63, as in earlier years, grade I would have amounted to the following per-
centages of total rated offerings: 1960, 24.1; 1961, 13.3; 1962, 15.9; 1963, 19.4.o
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Trends in Corporate Bond Quality

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Research Papers in Economics