Credit Ratings and Credit Risk

Why This Topic Matters

Credit ratings and credit risk sit at the heart of a treasury professional's work. A company's credit rating directly determines its cost of capital, its access to the debt markets, the terms and covenants lenders impose, and even whether it can issue commercial paper at all. On the other side of the ledger, treasury must assess the credit risk of the counterparties it deals with: banks holding its deposits, issuers of the securities in its short-term investment portfolio, derivative counterparties, suppliers, and customers. In the AFP CTP exam, this topic appears in the Capital Structure and Long-Term Capital domain, but it also connects to working capital, short-term investing, risk management, and relationship management. Expect questions that test both factual recall (rating scales, agency names, the investment-grade cutoff) and applied judgment (how a downgrade affects a company, how treasury mitigates counterparty exposure).

What Is Credit Risk?

Credit risk is the risk that a borrower or counterparty will fail to meet its financial obligations in full and on time. It can be broken into several related forms:

• Default risk – the issuer fails to pay interest or principal when due.
• Downgrade (migration) risk – the issuer's rating is lowered, reducing the market value of its outstanding debt and raising its future borrowing cost.
• Credit spread risk – the yield premium over risk-free securities widens because of market-wide or issuer-specific concerns, even without a formal rating change.
• Counterparty risk – a trading partner (bank, derivative dealer, customer) fails to perform under a contract.
• Settlement risk – one party delivers its side of a transaction but the other does not.
• Sovereign/country risk – a government imposes controls or defaults, which can cap the ratings of entities domiciled there (the sovereign ceiling).

Credit risk is often quantified using three components:

Expected Loss = Probability of Default (PD) × Loss Given Default (LGD) × Exposure at Default (EAD)

LGD equals 1 minus the recovery rate. For example, if a $10 million exposure has a 2% probability of default and an expected recovery of 40%, expected loss = $10,000,000 × 0.02 × 0.60 = $120,000. Questions on the CTP may ask you to compute or interpret one of these components.

What Is a Credit Rating?

A credit rating is an independent opinion of the creditworthiness of an issuer (an issuer rating) or of a specific debt obligation (an issue rating). Ratings are issued by credit rating agencies, the three dominant ones being Standard & Poor's (S&P), Moody's Investors Service, and Fitch Ratings. In the United States, agencies registered with the SEC are designated as Nationally Recognized Statistical Rating Organizations (NRSROs).

Key points about ratings:

• Ratings assess relative likelihood of timely payment, not the market price or interest-rate risk of a bond.
• Issue ratings may differ from issuer ratings because of seniority, security (collateral), and structural subordination. Senior secured debt is generally rated at or above the issuer rating; subordinated debt is typically rated below it.
• Most corporate ratings are issuer-paid, meaning the company requesting the rating pays the agency. This creates a potential conflict of interest that regulators addressed after the 2008 financial crisis (e.g., Dodd-Frank in the U.S.).
• A split rating occurs when agencies assign different ratings to the same issuer or issue; investors often use the lower of the two or a defined convention stated in the investment policy.

Long-Term Rating Scales

The investment-grade/speculative-grade boundary is the single most tested fact in this area.

S&P and Fitch: AAA, AA, A, BBB (investment grade) | BB, B, CCC, CC, C, D (speculative grade). Plus and minus modifiers are used from AA to CCC (e.g., A+, A, A-).

Moody's: Aaa, Aa, A, Baa (investment grade) | Ba, B, Caa, Ca, C (speculative grade). Numerical modifiers 1, 2, 3 are used from Aa to Caa (e.g., A1, A2, A3).

Investment grade = BBB- / Baa3 and above.
Speculative grade (also called high yield, non-investment grade, or junk) = BB+ / Ba1 and below.

Terminology to know: a fallen angel is an issuer downgraded from investment grade to speculative grade; a rising star is an issuer upgraded from speculative to investment grade. Both events trigger significant forced selling or buying because many institutional investors are restricted to investment-grade holdings.

Short-Term Rating Scales

Short-term ratings apply to obligations with original maturities generally of one year or less, most importantly commercial paper (CP).

S&P: A-1+ , A-1, A-2, A-3 (investment grade) | B, C, D
Moody's: P-1, P-2, P-3 (Prime) | NP (Not Prime)
Fitch: F1+, F1, F2, F3 | B, C, D

The approximate mapping to long-term ratings: A-1+/P-1 corresponds to roughly AA- and above; A-1/P-1 to roughly A and above; A-2/P-2 to roughly BBB+ to A-; A-3/P-3 to roughly BBB and BBB-. Access to the CP market is effectively limited to A-2/P-2 and better, and the deepest, cheapest tier requires A-1/P-1. Money market funds governed by SEC Rule 2a-7 face limits on holdings below the top tier, so a downgrade from A-1/P-1 to A-2/P-2 can sharply shrink an issuer's investor base. Lower-rated issuers often need backup liquidity facilities or a letter of credit (asset-backed or LC-backed CP) to issue.

Outlooks and Watch Lists

Agencies communicate the likely direction of a rating through:

• Rating outlook – positive, negative, stable, or developing; indicates the possible direction over the intermediate term (typically 6 months to 2 years).
• Credit watch / review – signals a possible rating change in the near term (usually within 90 days), often tied to a specific event such as a merger, large acquisition, or litigation outcome.

A negative outlook does not itself change the rating, but markets typically widen the issuer's spreads immediately.

How the Rating Process Works

1. The issuer requests a rating and pays a fee.
2. The agency assigns analysts, who review public filings, management presentations, projections, and confidential information.
3. Analysts evaluate business risk (industry cyclicality, competitive position, country risk, diversification, management quality) and financial risk (leverage, coverage, cash flow, liquidity, financial policy).
4. A rating committee votes; the issuer is notified and may appeal with new information.
5. The rating is published and then surveilled on an ongoing basis.

Typical financial ratios used by agencies and frequently referenced on the exam:

• Debt / EBITDA – leverage; lower is stronger.
• EBITDA / Interest or EBIT / Interest – interest coverage; higher is stronger.
• Funds from Operations (FFO) / Total Debt – cash flow capacity to repay debt; higher is stronger.
• Total Debt / Total Capital – capital structure leverage.
• Free operating cash flow / Debt – discretionary cash flow after capital expenditures.

Treasury professionals often manage the capital structure to target a rating: a company may deliberately maintain leverage within the range consistent with an A or BBB rating to preserve CP access and keep its weighted average cost of capital low.

How Ratings Affect the Company

• Cost of debt – each notch lower generally means a wider credit spread and a higher coupon. The jump from investment grade to speculative grade is the costliest step.
• Market access – lower ratings may close off the CP market, the public bond market, or certain investor classes, forcing reliance on bank credit or the high-yield market.
• Covenants – weaker credits face tighter financial covenants, collateral requirements, and more restrictive negative covenants.
• Rating triggers – contractual clauses in loan agreements, derivatives (ISDA Credit Support Annexes), leases, and supply contracts that require collateral posting, pricing step-ups, or early termination if the rating falls below a threshold. Treasury must inventory these because a downgrade can create a sudden liquidity drain (a death spiral risk).
• Pricing grids – many bank credit facilities tie the interest margin and commitment fee to the borrower's rating or leverage ratio.
• Counterparty acceptance – customers, suppliers, and derivative dealers may demand security or refuse to transact with low-rated firms.
• Pension and insurance considerations – rating-sensitive stakeholders may demand additional assurance.

Treasury's Management of Credit Risk Exposure

Treasury is both rated and a rater. In assessing others, treasury commonly:

• Writes an investment policy that sets minimum ratings (e.g., A-1/P-1 for CP, AA- for longer instruments), concentration limits per issuer, and actions required if a holding is downgraded (sell, hold to maturity, escalate).
• Sets counterparty limits for banks, including deposits, derivatives, and undrawn credit commitments, scaled to the bank's rating.
• Uses credit default swap (CDS) spreads and market-implied ratings as faster-moving indicators than agency ratings.
• Performs customer credit analysis using the Five Cs (Character, Capacity, Capital, Collateral, Conditions), credit bureau reports (e.g., Dun & Bradstreet), and financial statement analysis.
• Employs mitigation tools: collateral, guarantees, standby letters of credit, credit insurance, netting agreements, credit derivatives, factoring without recourse, diversification, shorter tenors, and trade credit terms such as cash in advance.
• Monitors credit migration and maintains contingency funding plans for its own potential downgrade.

Worked Example

Scenario: A company rated A-/A3 with A-2/P-2 commercial paper is placed on credit watch negative after announcing a debt-financed acquisition that will raise Debt/EBITDA from 2.0x to 3.5x. What should treasury anticipate?

Analysis: A downgrade to BBB+/Baa1 would likely drop the CP rating to A-2/P-2 at best or lose CP access altogether if it falls to A-3/P-3. Treasury should (1) ensure backup bank lines fully cover outstanding CP, (2) review all rating triggers in derivative and loan documents for collateral calls, (3) consider terming out CP into longer-dated bonds before the downgrade is finalized, (4) communicate a deleveraging plan to the agencies to preserve the investment-grade rating, and (5) model the higher interest cost under the pricing grid in the revolving credit facility.

Exam Tips: Answering Questions on Credit Ratings and Credit Risk

1. Memorize the investment-grade cutoff cold. BBB-/Baa3 is the lowest investment-grade rating; BB+/Ba1 is the highest speculative-grade rating. Many questions hinge on this single boundary.

2. Know all three agencies' notation. Recognize that Baa2 is Moody's, BBB is S&P/Fitch, and that P-1 pairs with A-1 and F1. If a question gives Moody's notation, translate it mentally to the S&P equivalent before answering.

3. Match short-term ratings to CP access. If a question involves commercial paper issuance, the answer almost always relates to A-1/P-1 (top tier, broadest access and lowest cost) versus A-2/P-2 (limited access) versus below (effectively no unsecured access without credit enhancement).

4. Distinguish issuer ratings from issue ratings. If a question describes a subordinated or unsecured bond rated lower than the company's own rating, the explanation is seniority and collateral, not an error.

5. Understand what a rating is NOT. Ratings do not address interest-rate risk, liquidity (market) risk, or price volatility. They are opinions on the likelihood of timely payment. Eliminate answer choices that describe ratings as guarantees or as measures of market price.

6. Read for direction words. Outlook = intermediate-term direction; watch/review = near-term event-driven possible change. A negative outlook is not a downgrade.

7. Be ready to compute expected loss. Expected Loss = PD × LGD × EAD, and LGD = 1 − recovery rate. Watch for questions that give recovery rate rather than LGD.

8. Think like a treasurer when asked about consequences. When a question asks for the effect of a downgrade, the best answer usually involves higher borrowing cost, restricted market access, triggered collateral or covenant requirements, or the need for backup liquidity. When asked how to protect the company, look for answers involving backup lines, deleveraging, terming out debt, and reviewing rating triggers.

9. Apply investment-policy logic. For questions on short-term investing, the conservative answer favors high ratings, diversification, concentration limits, and defined procedures for downgraded securities. Beware of answers that ignore split ratings; policies normally specify using the lowest rating or a rule for resolving the split.

10. Recognize the vocabulary. Fallen angel, rising star, split rating, sovereign ceiling, rating trigger, pricing grid, NRSRO, issuer-paid model, credit watch, migration risk, and counterparty risk are all fair game as the key to a question.

11. Eliminate extremes. CTP questions reward balanced, policy-driven answers. Choices suggesting that treasury should ignore ratings entirely, or rely on ratings exclusively without independent analysis, are usually wrong. The best practice is to use ratings as one input alongside internal analysis, market indicators such as CDS spreads, and defined exposure limits.

12. Connect to capital structure. Remember that a target credit rating is a deliberate capital-structure decision. Questions linking leverage ratios, cost of capital, and rating outcomes expect you to understand that adding debt lowers WACC only up to the point where rising credit risk and the loss of investment-grade status push the cost of debt and equity higher.

Quick Reference Summary

• Credit risk = risk of non-payment; forms include default, downgrade, spread, counterparty, settlement, sovereign.
• Expected Loss = PD × LGD × EAD.
• Big three agencies: S&P, Moody's, Fitch; regulated as NRSROs.
• Investment grade: AAA to BBB- (S&P/Fitch), Aaa to Baa3 (Moody's).
• Short-term: A-1+/A-1/A-2/A-3 (S&P), P-1/P-2/P-3/NP (Moody's), F1+/F1/F2/F3 (Fitch).
• CP market effectively requires A-2/P-2 or better; A-1/P-1 for lowest cost and widest access.
• Outlook = medium-term direction; watch = near-term event-driven.
• Downgrade consequences: higher spreads, lost market access, rating triggers, collateral calls, tighter covenants.
• Treasury mitigants: policy limits, diversification, collateral, guarantees, LCs, credit insurance, netting, backup liquidity, monitoring CDS spreads.

Master these fundamentals, practice translating between agency scales, and always frame your answer from the perspective of a prudent treasury professional protecting liquidity and minimizing the cost of capital. That approach will carry you through virtually any CTP question on credit ratings and credit risk.