Question

(Related to the Apply the Concept on page 259 ) According to an article by Reuters News Agency, in November \(2016,\) Fitch Ratings cut its rating on McDonald's bonds from \(B B B+\) to \(B B B\). a. What is Fitch's top bond rating? Under what circumstances would Fitch, or the other bond rating agencies, be likely to cut the rating on a firm's bonds? b. What will be the likely result of this rating's cut for the interest rate McDonald's will have to pay when it sells new bonds? Briefly explain.

Short answer

Fitch's top bond rating is 'AAA'. Fitch or other agencies would cut a firm's bond ratings when there are concerns about the firm's financial health and risks associated with their ability to service debt. The likely result of a rating cut for McDonald's is that it will have to pay higher interest rates when it sells new bonds because investors will demand a higher return for the increased risk.

Step-by-step solution

Explanation of Fitch's top bond rating

Fitch's bond rating scale starts from the lowest 'D' (default) and goes up to the highest 'AAA', denoting the lowest and highest credit quality respectively. Therefore, Fitch's top bond rating is 'AAA', indicating the issuing organization has a very low risk of default and is thus most creditworthy.

Circumstances leading to rating cut

Bond rating agencies like Fitch downgrade the rating on a firm's bonds under several circumstances, such as deteriorating financial health, increased risk of default, negative business outlook, or major adverse economic factors. Essentially, when the agency believes the firm's ability to pay back its debt has weakened, it will cut the rating on its bonds.

Impact of rating cut on interest rates

A downgrade in bond rating does not bode well for the organization as it signals increased risk to the investors. To compensate for this increased risk, investors demand higher yield (interest rate) on these bonds. Consequently, if McDonald's wants to sell new bonds post the rating cut, it will likely have to pay higher interest rates than before.

Key concepts

Understanding Credit Quality

When it comes to bonds, credit quality serves as an indicator of the bond issuer's ability to repay the debt. It is assessed by evaluating the financial strength and stability of the issuer. Organizations with high credit quality are seen as less risky and therefore have an easier time borrowing money at lower interest rates. Agencies like Fitch evaluate credit quality periodically and express their opinion through a bond rating scale.

The highest rating is 'AAA', signaling superb credit quality. The further down the scale you go, the more the credit quality diminishes. For instance, a rating of 'BBB' is decent but indicates more risk than an 'AA' or 'AAA' rating. An investor looking at the rating can quickly assess the risk associated with a bond investment – the lower the rating, the higher the perceived risk, and vice versa. Thus, credit quality is an essential factor for both issuers and investors in the bond market as it directly impacts financing costs and investment decisions.

The Risks of Default

Another crucial concept in the bond market is default risk, the likelihood that the bond issuer will not honor the debt obligation as agreed upon at maturity. Default can occur for various reasons, such as poor cash flow, changing market conditions, or mismanagement. When a company like McDonald's faces a ratings downgrade like from 'BBB+' to 'BBB', it reflects a perceived increase in default risk.

Rating agencies monitor an array of financial metrics and predictive indicators to foresee default risks. If they suspect higher risk, they may downgrade a company's bonds. Such downgrades can create a ripple effect, prompting a reassessment of the issuer's creditworthiness and leading investors to demand higher yields for taking on additional risk. This makes raising capital more expensive for the company. Default risk is a critical factor in investment decision-making, particularly for conservative investors or those with a low risk tolerance.

Interest Rates and Their Economic Implications

The bond rating changes have direct implications on interest rates that bond issuers like McDonald's must pay to attract investors. As the default risk increases, so do the interest rates; they are inversely related to bond prices and directly proportionate to the bond's yield. Higher rates compensate for the increased risk investors perceive due to lower credit quality.

After a downgrade, to sell new bonds, a firm will generally have to offer a higher interest rate to make the bonds appealing despite the higher risk. In the broad economic picture, interest rates have a profound effect on the overall economy - influencing consumer spending, business investment, currency strength, inflation, and much more. Understanding how bond ratings influence interest rates is critical not just for corporations that need to finance their operations but also for investors looking to balance their risk and return.