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Dale Jackson

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At debt's door

Dale Jackson

TORONTO (GlobeinvestorGOLD) — On July 9, Moody's Investors Service Inc. downgraded the debt of Alcatel SA, a French telecom-equipment maker, to junk-bond territory. Within minutes of the announcement, Alcatel's shares plummeted 13 per cent.

It's not just investors who recoil at debt downgrades. In June, the Japanese government took the unprecedented step of calling a Moody's representative before a Lower House committee to explain why the debt agency cut the credit rating of the world's second-largest economy. The new rating placed Japan below Botswana — an African nation whose largest creditor is Japan.

What's the big deal about lowering a company — or country's — credit rating a few measly notches? After all, a lot of us got through high school with Bs and Cs. Well, for the issuer it means higher borrowing rates and a loss of credibility. For the investor, it's the difference between getting a return on your investment and getting diddly-squat.

To understand the risks associated with lending, you must know how the various rating services grade debt.

The most common global debt rating agencies are Moody's and Standard & Poor's. Smaller Canadian debt issuers are also covered by Dominion Bond Rating Service and Canadian Bond Rating Service. Two years ago, Canadian Bond Rating Service was bought by Standard & Poor's and is currently being amalgamated.

Bond and debenture-rating services scrutinize the financial statements of the governments and companies they cover and assess their debt positions. The rating they assign indicates the probability of uninterrupted payment of interest, repayment of principal and currency risks. If the debt position changes, so does the rating.

Moody's is truly a global player, providing credit ratings and analysis on more than $30 trillion (U.S.) of debt. From its New York headquarters and offices in 17 countries, more than 800 risk analysts stretch the corners of the globe looking for debt issues significant enough to rate. They also provide a vital service by linking borrowers with lenders.

According to the Moody's rating scale, bonds which are rated Aaa are judged to be of the best quality and carry the smallest degree of investment risk. Interest and principle payments are secured by a large margin. A Triple-A rating is most often awarded to stable governments which have the power to increase margins through legal powers of taxation. If the margins shrink, Moody's downgrades the bonds to Aa. When elements suggest the issuer is susceptible to default some time in the future, the debt is rated with a single A.

Baa debt is considered medium grade with "speculative" qualities. Just how speculative they are determines lower ratings of Ba and B. If debt displays characteristics of volatility, it is ranked between the three ratings for each letter with numbers one through three.

In the case of Alcatel, the company's senior debt rating was reduced to Ba1 from Baa2 — junk bond territory. Moody's also maintained a negative outlook on the company, forecasting "continued declines in telecom-equipment demand over the next two years." With that ratings reduction, Alcatel jumped on the junk bandwagon with the likes of Lucent Technologies Inc. and Nortel Networks Corp.

According to Moody's, any C-rated debt involves a history of default with the possibility of future default. Debt goes into default when the debtor fails to make principal and interest payments by the designated time. That does not necessarily mean the investor is left high and dry. A study by Moody's found that between 1938 and 1995, the estimated recovery rate for bonds that went into default was 43 per cent of the principal.

Standard & Poors Long-Term Debt and Moody's Ratings Equivalents
Moody's Standard & Poors
Investment Grade:
Exceptional Aaa, Aaa1, Aaa2, Aaa3 AAA, AAA-, AA+
Excellent Aa, Aa1, Aa2, Aa3 AA, AA-, A+
Good A, A1, A2, A3 A, A-, BBB+
Adequate Baa, Baa1, Baa2, Baa3 BBB, BBB-, BB+
Speculative Grade:
Questionable Ba, Ba1, Ba2, Ba3 BB, BB-, B+
Poor B, B1, B2, B3 B, B-, CCC+
Very Poor Caa, Caa1, Caa2, Caa3 CCC, CCC-, CC+
Extremely Poor Ca, Ca1, Ca2, Ca3 CC,CC-, C+
Lowest C C

Also based in New York, Standard & Poor's is Moody's chief competitor in the debt rating game. During its 140 years in business, the company established the S&P500 as a benchmark for the U.S. stock market which still stands today. Standard & Poor's prides itself on a tradition of objectivity and accuracy.

Currently, 60 S&P analysts in 21 offices around the world provide the same function as Moody's — but with a different ratings scale. Each ratings scale is devised with the intention of being more accurate and objective than the competition. It also serves the market by giving differing points of view to the same debt instruments.

Standard & Poor's considers investment-grade bonds to range from AAA to BBB. AAAf is the highest rating and CCCf is the lowest. Volatility ratings range from lowest, S1, to highest, S6. Bonds may be further ranked with a plus or minus rating. S&P rates "junk" at or below BBB.

Canadian Bond Rating Service ranks debt from A++ to D, and Dominion Bond Rating Service uses a scale much like Standard & Poor's. In most cases, the rating is accompanied with an explanation that may indicate when the debt will be reviewed again and which way the new rating could go.

Like stocks, bonds follow the rules of risk and reward. The higher the risk, the higher the yield. The safest short-term government bonds can pay out less than 3 per cent per year while the riskiest junk bonds can pay yields of over 17 per cent. The term "junk" may be misleading because it implies the bond is worthless when in fact it has a generous payout — assuming it has a payout at all. A more accurate term for junk would be "highly speculative."

Corporate bonds normally pay higher yields than government bonds because they possess a greater risk of default. Like stocks, fixed-income fund managers maximize returns and reduce risk by holding a mix of debt-rated securities in an investment portfolio. They also mix terms-to-maturity in a strategy known as laddering. By staggering maturities, bonds mature frequently, giving the investor several opportunities to shop for the best yields on the market.

One caveat with credit agencies: no matter what the rating, there's no protection from corporate accounting fraud. Like equity analysts, debt analysts can only work with the numbers given to them by the institution under scrutiny. If the numbers have been fudged, the rating is inaccurate.

For more information on debt ratings, visit these sites:

Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.

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