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Low Credit Rating Risk

Just how much risk is associated with a low credit rating? The issue of low credit rating risk came to the fore last week when Standard and Poor’s downgraded their credit ratings for nine nations in the European Union. High on the list of investing tips for beginning investors as well as experienced investors is the need for an understanding of low credit rating risk. There are three major credit rating agencies in the United States. They are Fitch, Moody’s, and Standard and Poor’s. These agencies evaluate the creditworthiness of investments. This includes both governmental and corporate issuers of bonds, other forms of debt such as loans issued by banks, and entire bank loan portfolios, and entire nations in regard to doing business and investing. The point of these ratings is to estimate the potential for default on loans, bond payments, or even business failure in regard to investment in projects within nations. The low credit rating issue that is in the news this week is that Standard and Poors has essentially said that nine separate European nations are one step closer to defaulting on their nation debt obligations. France and Austria lost their previously perfect AAA ratings.

What does a low credit rating risk mean for an investor? The amount of investment research that the average investor can do is limited. On the other hand companies such as Fitch, Moody’s, and Standard and Poor’s have analysts whose job it is to make sense of the diverse information, both public and private, that goes into a credit rating. A low credit rating has a high association with a risk of default. We list here the ratings used by the three credit rating agencies and a description of risk.

Fitch Moody’s S&P Description
Long-term Short-term Long-term Short-term Long-term Short-term
AAA F1+ Aaa P-1 AAA A-1+ Prime
AA+   Aa1   AA+   High grade
AA   Aa2   AA    
AA-   Aa3   AA-    
A+ F1 A1   A+ A-1 Upper medium grade
A   A2   A    
A- F2 A3 P-2 A- A-2  
BBB+   Baa1   BBB+   Lower medium grade
BBB F3 Baa2 P-3 BBB A-3  
BBB-   Baa3   BBB-    
BB+ B Ba1 Not prime BB+ B Non-investment grade
BB   Ba2   BB   speculative
BB-   Ba3   BB-    
B+   B1   B+   Highly speculative
B   B2   B    
B-   B3   B-    
CCC C Caa1   CCC+ C Substantial risks
    Caa2   CCC   Extremely speculative
    Caa3   CCC-   In default with little
    Ca   CC   prospect for recovery
        C    
DDD / C   D / In default
DD   /        
D   /        

Traditionally, investors are interested in long term investment risk. However, investors in the chaotic markets of today are often more concerned with the short term/one year risk of losing their investment capital. A short term low credit rating risk implies that a nation or corporation may be close to insolvency. The S&P downgrade did not have to do specifically with the risk of investing in Austria, France, or the other nations just downgraded. It has to do with the risk of these nations being able to pay their own bills. This specifically is an issue for the EU rescue fund to which all EU nations contribute money. If the EU rescue fund becomes insolvent the rescue of the Southern tier European nations could be in jeopardy. If the EU loses several members the EU itself could be in jeopardy as a political and economic institution. For those interested in investing in European companies or Euro denominated bonds sound fundamental analysis would include evaluation of opportunities with both high and low credit rating risk.

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