Credit ratings and CDO risks

For investors in interest rate securities, surety over the ability for the issuer to make promised repayments is crucial.  In order to make an evaluation of the likelihood of the coupon payment occurring, investors often rely on credit rating agencies to publish credit ratings, which reflect their analysis of an issuer or issued securities.  Credit ratings are designed to give some guidance on coupon payment certainty. 

Most corporate interest rate securities are evaluated for credit quality by agencies such as Fitch, Moody's Investors Services and Standard & Poor's (their rating systems are listed in the table below).

 

Fitch Moody's Standard & Poor's What the rating means
Investment Grade
AAA Aaa AAA Highest credit quality
AA Aa AA Very high credit quality
A A A High credit quality
BBB Baa BBB Good credit quality
Non-investment Grade
BB Ba BB Speculative
B B B Highly speculative
CCC Caa CCC High Default Risk
CC Ca C High Default Risk
C C C High Default Risk
DDD C D Default
DD C D Default
D C D Default

If a company and its debt securities are unrated, it does not necessarily mean that it is high risk, but it does mean that investors will have to turn to other means to evaluate its financial strength.   In the case of unrated securities, self-analysis of their credit worthiness becomes increasingly difficulty the more complex the deal structure becomes.

Collateralised debt obligations (CDOs) are perhaps the most complex debt security on issue.  (Find out more about CDOs LINK)  These are a structured debt security that may suit clients looking for a high yield product, generally for accepting to take on the credit risk associated with a portfolio of debt. 

To understand the risk associated with a CDO, you as the adviser may need to determine with your client what tranche their particular investment note is part of.  When a CDO is designed, the credit risk and the interest payments are divided up into three broad categories.  The first category and the riskiest investment note is the “first loss piece”.  This may be accepted by the initiating issuer as a display of aligning their interests with investors.  The second section is the subordinated notes, generally ranked from BBB to AA.  These notes offer a range of returns commensurate with their credit rating.  The final section is the senior notes, generally rated AAA.  These notes will have the lowest default risk and as such pay the lowest return of the three groups.

 Credit ratings and CDO risks - steps involved

Investors in a CDO are exposed to the risk of default by the underlying debt portfolio.  When considering the risk involved in each tranche, the “thickness” of the tranche below it will determine how many credit events can be absorbed before an investor feels any pain.  This number of credit events that will result in investor losses is outlined in the prospectus that accompanies a CDO issue.

Taking the idea of structural risk further - some retail CDOs are designed with income step-down features.  This means that in the event of a certain number of credit events occurring the coupon amount may be stepped-down, eventually to zero.  This may be an important consideration for income investors.

In the event of coupon step-down, a further risk that may emerge is liquidity risk.  In the event of a CDO losing its coupons there is a chance that the market for the security becomes very thin.  In this instance an investor may find their funds locked in until the CDO’s maturity date.

Finally, interest rate risk is a feature with all debt securities. The basic premise being that as interest rates rise, bond prices fall.  This is due to the drop in demand for securities on issue as investors switch to new, higher yield products.  A debt security with a floating-rate will have the ability to buck this trend, as their coupon is determined by a margin over bank bills.