assessment of default risk a little easier for us when analyzing companies. In its absence,
we would still have to assess default risk on our own and come up with estimates of the
default spread we would charge if we were lending to a firm.
ratings.xls: There is a dataset on the web that summarizes default spreads by
bond rating class for the most recent period.
In Practice: Ratings Changes and Interest Rates
The rating assigned to a company can change at the discretion of the ratings
agency. The change is usually triggered by a change in a firm’s operating health, a new
security issue by the firm or by new borrowing. Other things remaining equal, ratings will
drop if the operating performance deteriorates or if the firm borrows substantially more
and improve if it reports better earnings or if it raises new equity. In either case, though,
the ratings agency is reacting to news that the rest of the market also receives. In fact,
ratings agencies deliberate before making ratings changes, often putting a firm on a credit
watch list before changing its ratings. Since markets can react instantaneously, it should
come as no surprise that bond prices often decline before a ratings drop and increase
before a ratings increase. In fact, studies indicate that much of the bond price reaction to
deteriorating credit quality precedes a ratings drop.
This does not mean that there is no information in a ratings change. When ratings
are changed, the market still reacts but the reactions tend to be small. The biggest service
provided by ratings agencies may be in providing a measure of default risk that is
comparable across hundreds of rated firms, thus allowing bond investors a simple way of
categorizing their potential investments.
Conclusion
Risk, as we define it in finance, is measured based upon deviations of actual
returns on an investment from its' expected returns. There are two types of risk. The first,
which we call equity risk, arises in investments where there are no promised cash flows,
but there are expected cash flows. The second,, default risk, arises on investments with
promised cash flows.