Credit Ratings and Cost of Capital

You may be wondering why a credit downgrade of US Gov’t Debt from AAA to AA+ has received so much attention, if so you aren’t alone. I enthusiastically mentioned the news to my wife and a couple friends two nights ago and a mixed look of dread and boredom immediately flashed…

Well, simply put, credit ratings directly affect the cost of borrowing and we know the US Government has a huge debt burden.

Corporations (and governments) with good credit ratings can access debt cheaper than those with poor credit ratings. Credit ratings rank from AAA to CCC+ (anything below CCC+ is effectively being priced for Default).

But there’s a catch… the difference in cost of capital is not linear, it is exponential…

The above chart shows an off-the-cuff example of how credit ratings can affect the cost of borrowing. The drop-off below investment grade happens quick, and for good reason. As we will see in the next chart, the probability of default similarly increases exponentially as a credit falls down the credit rating scale.

EG: over 1-year, a BBB- credit has a 36 bps chance of defaulting whereas a Speculative Grade bond (BB+ or worse) averages a 400 bps chance of default - over 10x higher than its BBB- counterpart!

Keep in mind that a “default” means anything from a late payment, to tripping a covenant, to a missed payment (what most people think of when the word default is used). What I find most interesting about the below chart, in the context of the US Gov’t Debt downgrade, is that AA+ issuers actually performed better than AAA issuers from year 3-5. That is interesting since AAA issuers are considered to be “risk-free”.

The last item to discuss on this post is how the cost of capital can affect corporate structure.

It makes sense that companies will rely more or less on debt depending on its price and availability to such company. However, one of the great ironies in debt capital markets is the contradiction that “banks want to lend to companies with the best financial health, but companies in the best financial health won’t have as much appetite for debt financing as their less healthy counterparts”. This is because companies in the best financial health can fund their business and new projects with internally generated cashflow. Companies with poor financial health often find that the equity markets are extremely expensive or outright closed to new issuance, so they turn to high-interest debt providers.