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292
Part 5 Financial Markets
TA B L E 1 2 . 2
Debt Ratings
Standard
and Poor’s
Moody’s
Average Default
Rate (%)*
Definition
AAA
Aaa
0.00
Best quality and highest rating. Capacity to pay interest and
repay principal is extremely strong. Smallest degree of
investment risk.
AA
Aa
0.02
High quality. Very strong capacity to pay interest and repay
principal and differs from AAA/Aaa in a small degree.
A
A
0.10
Strong capacity to pay interest and repay principal. Possess
many favorable investment attributes and are considered
upper-medium-grade obligations. Somewhat more suscepti-
ble to the adverse effects of changes in circumstances and
economic conditions.
BBB
Baa
0.15
Medium-grade obligations. Neither highly protected nor
poorly secured. Adequate capacity to pay interest and
repay principal. May lack long-term reliability and protec-
tive elements to secure interest and principal payments.
BB
Ba
1.21
Moderate ability to pay interest and repay principal. Have
speculative elements and future cannot be considered well
assured. Adverse business, economic, and financial condi-
tions could lead to inability to meet financial obligations.
B
B
6.53
Lack characteristics of desirable investment. Assurance of
interest and principal payments over long period of time
may be small. Adverse conditions likely to impair ability to
meet financial obligations.
CCC
Caa
24.73
Poor standing. Identifiable vulnerability to default and
dependent on favorable business, economic, and financial
conditions to meet timely payment of interest and
repayment of principal.
CC
Ca
24.73
Represent obligations that are speculative to a high degree.
Issues often default and have other marked shortcomings.
C
C
24.73
Lowest-rated class of bonds. Have extremely poor prospects
of attaining any real investment standard. May be used to
cover a situation where bankruptcy petition has been
filed, but debt service payments are continued.
CI
Reserved for income bonds on which no interest is
being paid.
D
Payment default.
NR
No public rating has been requested.
(+) or (–)
Ratings from AA to CCC may be modified by the addition
of a plus or minus sign to show relative standing within
the major rating categories.
*Average default rates are for data Moody’s computed for defaults within one year of having given the rating for the
period 1970–2001.
Source:
Federal Reserve Bulletin.
Chapter 12 The Bond Market
293
During the early and mid-1980s, many firms took advantage of junk bonds to
finance the takeover of other firms. When a firm greatly increases its debt level (by
issuing junk bonds) to finance the purchase of another firm’s stock, the increase in
leverage makes the bonds high risk. Frequently, part of the acquired firm is even-
tually sold to pay down the debt incurred by issuing the junk bonds. Some 1,800 firms
accessed the junk bond market during the 1980s.
Milken and his brokerage firm were very well compensated for their efforts.
Milken earned a fee of 2% to 3% of each junk bond issue, which made Drexel the most
profitable firm on Wall Street in 1987. Milken’s personal income between 1983 and
1987 was in excess of $1 billion.
Unfortunately for holders of junk bonds, both Milken and Drexel were caught and
convicted of insider trading. With Drexel unable to support the junk bond market,
250 companies defaulted between 1989 and 1991. Drexel itself filed bankruptcy in
1990 due to losses on its own holdings of junk bonds. Milken was sentenced to three
years in prison for his part in the scandal. Fortune magazine reported that Milken’s
personal fortune still exceeded $400 million.
2
The junk bond market had largely recovered since its low in 1990, but the finan-
cial crisis in 2008 again reduced the demand for riskier securities.
Financial Guarantees for Bonds
Financially weaker security issuers frequently purchase financial guarantees to
lower the risk of their bonds. A financial guarantee ensures that the lender (bond
purchaser) will be paid both principal and interest in the event the issuer defaults.
Large, well-known insurance companies write what are actually insurance policies to
back bond issues. With such a financial guarantee, bond buyers no longer have to
be concerned with the financial health of the bond issuer. Instead, they are interested
only in the strength of the insurer. Essentially, the credit rating of the insurer is
substituted for the credit rating of the issuer. The resulting reduction in risk lowers
the interest rate demanded by bond buyers. Of course, issuers must pay a fee to
the insurance company for the guarantee. Financial guarantees make sense only
when the cost of the insurance is less than the interest savings that result.
In 1995 J.P. Morgan introduced a new way to insure bonds called the credit
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