BM2004

Managing Credit Risk

Credit Risk and Interest Rates

Credit risk, otherwise known as default risk, is the risk that the borrower will not be able to pay its obligation.
As one of the factors in determining the cost of lending or financing using debt, credit risk must be assessed.

The Five Cs
The Five Cs of credit, which is consist of quintet characteristics, is a system used by lenders to gauge the
creditworthiness of potential borrowers. It is composed of the following:
1. Character, which is reflected in the applicant's credit history.
2. Capacity, which is the applicant's debt-to-income ratio.
3. Capital, which is the amount of money an applicant has.
4. Collateral, which is an asset that can back or act as security for the loan.
5. Conditions, which are the purposes of the loan, the amount involved, and prevailing interest rates.

The debt-to-income ratio is the ratio of the monthly debt of a person to his/her gross monthly income.

Theories in Setting Interest Rates

An interest rate reflects the rate of return that a creditor receives when lending money, or the rate that a
borrower pays when borrowing money. Since interest rates change over time, so does the rate earned by
creditors who provide loans or the rate paid by borrowers who obtain loans. Thus, participants in financial
markets attempt to anticipate interest rate movements when restructuring their investment or loan positions
leading to the development of various theories. The following are the three (3) theories used in determining
interest rates: (Madura, 2020)

1. Loanable Funds Theory – Knuck Wicksell introduced it in the 1900s. The theory is useful in explaining the
level of the general movement of interest rates for a particular country. It assumes that the higher the
interest rates, sectors in the market will be more willing to supply loanable funds; the lower the level of
the interest, the less they are willing to provide.

The sectors also demand loanable funds when the level of interest is low and demand less when the level
of interest rate is high.

These sectors are the following (Madura, 2020):

a. Households – They commonly demand loanable funds to finance housing expenditures, purchase of
automobiles, and household items, which then results in installment debt. On the other hand, the
household sector is also the largest supplier of loanable funds because they save the most.
b. Businesses – They demand loanable funds to invest in long-term (fixed) and short-term assets. The
quantity of funds required by enterprises depends on the number of business projects to be
implemented. However, some businesses whose cash inflow exceed outflows act as a supplier of
loanable funds.
c. Government – It demands loanable funds when its planned expenditures cannot be entirely covered
by its incoming revenues from taxes and other sources. To obtain funds, the municipal governments
issue municipal bonds, while the national government and its agencies issue Treasury and agency
securities.
However, the government’s expenditure and tax policies are generally thought to be independent of
interest rates. Thus, its demand for funds is referred to as interest-inelastic, or insensitive to interest

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rates. Government units that temporarily generate more revenues than they spend act as a supplier
of loanable funds. They lent out the excess of the revenue over their expenses through loans and
programs for businesses and households. One of the examples is the offering of the Department of
Trade and Industry’s (DTI) 1 billion pesos loan package for micro, small, and medium enterprises
(MSMEs).

2. Expectations Theory – This theory assumes that interest rates are driven by expectations of the lender or
borrowers in risks that might be present in the market in the future. This theory attempts to predict what
short-term interest rates will be in the future based on current long-term interest rates.

There are two (2) expectation theories: (Madura, 2020)

a. Pure Expectations Theory – This theory believes that the term structure reflected in the shape of the
yield curve is determined solely by the expectations of interest rates.
To give a clear example, assume that the annualized yields of short-term and long-term risk-free
securities are similar; that is, the yield curve is flat. Then assume that the investors begin to believe
that interest rates will rise. Generally, investors will respond to the expected increase in interest rates
by investing their funds mostly in the short term so that they can soon reinvest them at higher yields
after the interest rates increase. This will lead to an increase in the supply of funds in the short-term
markets and a decrease in the long-term markets. On the other hand, borrowers will generally prefer
to issue long-term securities rather than short term securities, which leads to an increase in the
demand for long-term funds and a decrease for short-term funds. Overall, the said events will push
the yield curve upward. Thus, an expected increase in interest rates leads to an upward sloping yield
curve.
In contrast, when the investors expect interest rates to decrease in the future, they will prefer to invest
in long-term funds rather than short-term funds because they could lock in today’s interest rate before
interest rates fall. Borrowers will prefer to borrow short-term funds so that they can refinance at a
lower interest rate once interest rates decline. The said events will push the yield curve downward. In
short, an expected decrease in interest rates leads to a downward yield curve.
Moreover, this theory also assumes that the interest rate on a long-term bond will equal an average
of the short-term interest rates that people expect to occur over the life of the long-term bond. If
people expect that short-term interest rates will be 10% on average over the coming five (5) years,
the expectations theory predicts that the interest rate on bonds with five years to maturity will be
10% also. Under the above presumption, the interest under this theory can be determined using the
following formula:

(1+𝑡 𝑖2 )2 = (1+𝑡 𝑖1 )(1+𝑡+1 𝑟1 )

Where,
+𝑡 𝑖2 is the known annualized interest rate of two-year security at time 𝑡,
+𝑡 𝑖𝑖 is the known annualized interest rate of one-year security at time 𝑡, and
+𝑡+1 𝑟1 is the one-year interest rate that is anticipated as of time 𝑡 + 1. It is also known as the
forward rate.

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Illustrative Example:
A 1-year treasury bill has a coupon rate of 2%, and a 2-year treasury note has a coupon rate of 3%.
Based on the pure expectations theory, what is the 1-year interest rate that is anticipated at 𝑡 + 1
(2nd year)?

Answer:
Let +𝑡 𝑖2 = 3%;
+𝑡 𝑖𝑖 = 2%
+𝑡+1 𝑟1 = 𝑥
(1+𝑡 𝑖2 )2 = (1+𝑡 𝑖𝑖 )(1+𝑡+1 𝑟1 )

Substitute the given values in the formula,

(1.03)2 = (1.02)(1 + 𝑥)
Then, find the value of 𝑥,
1.0609 = 1.02 + 1.02𝑥
𝑥 = 4.00980%

Therefore, the 1-year interest rate that is anticipated in the 2nd year is 4.00980%.

b. Biased Expectations Theory – This theory proposes that the future value of interest rates is always
biased. It is based on expectations, sentiments, and what people expect from the market today. The
present market expectations affect the term structure of the loans as well as interest rates. Forward
rates (the interest rate that applies to financial transactions that will take place in the future) are
adjusted if the liquidity of the borrower will be weaker or more reliable in the future, this is also known
as a liquidity premium.

Biased Expectations Theory is further divided into two (2): the Liquidity Preference Theory and
Preferred Habit Theory. (Madura, 2020)
 Liquidity Preference Theory – John Maynard Keynes presented this in 1936. This theory believes
that investors prefer short-term liquid securities and may be willing only to invest in long term
securities if compensated with a premium for the lower degree of liquidity. According to Keynes,
there are three (3) motives that determine the demand for liquidity:
o Transactions motive – Individuals have a preference for liquidity to guarantee having sufficient
cash on hand for basic day-to-day needs. In other words, they have a high demand for liquidity
to cover their short-term obligations, such as buying groceries, paying rent and/or the
mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those day-
to-day needs.
o Precautionary motive – Individuals preferred additional liquidity if an unexpected problem or
cost arises that requires a substantial outlay of cash. These events include unforeseen costs
like a house or car repairs.
o Speculative motive – Individuals are reluctant to tie up investment capital for fear of missing
out on a better opportunity in the future. When the interest rates are low, the demand for cash
is high. As a response, individuals prefer to hold assets until interest rates will rise.

The formula below will be used in estimating the rates under the liquidity premium theory:

(1+𝑡 𝑖2 )2 = (1+𝑡 𝑖1 )(1+𝑡+1 𝑟1 ) + 𝐿𝑃2

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Where,
+𝑡 𝑖2 is the known annualized interest rate of two-year security at time 𝑡
+𝑡 ii is the known annualized interest rate of one-year security at time 𝑡
+𝑡+1 𝐹1 is a one-year interest rate that is anticipated as of time 𝑡 + 1
𝐿𝑃2 is the liquidity premium on 2-year security

Illustrative Example:
A 1-year treasury bill has a coupon rate of 2%, and a 2-year treasury note has a coupon rate of
3.2%. The 1-year interest rate that is anticipated at 𝑡 + 1 (2nd year) is 4.00980%. What is the
liquidity premium?

Answer:
Let +𝑡 𝑖2 = 3.2%;
+𝑡 𝑖𝑖 = 2%;
+𝑡+1 𝑟1 = 4.00098%; and
𝐿𝑃2 = 𝑥.

(1+𝑡 𝑖2 )2 = (1+𝑡 𝑖1 )(1+𝑡+1 𝑟1 ) + 𝐿𝑃2

Substitute the given values in the formula,

(1.032)2 = (1.02)(1.0400980) + 𝑥
Then, find the value of 𝑥,
1.065024 = 1.0608996 + 𝑥
𝑥 = 0.4124%

Therefore, the 1-year interest rate that is anticipated in the 2nd year is 0.4124%.

 Preferred Habitat Theory – This theory proposes that, although investors and borrowers may
normally concentrate on a particular maturity market, certain events may cause them to wander
from their “natural” market/habitat. The natural market is the range of security maturity the
investors and borrowers preferred. For example, commercial banks that obtain mostly short-term
funds may select investments with short-term maturities as a natural habitat. However, if they wish
to benefit from an anticipated decline in interest rates, they may select medium and long-term
maturities instead.

3. Market Segmentation Theory – This theory assumes that investors choose securities with maturities that
satisfy their forecasted cash needs rather than on their expectations of future interest rates. For example,
pension funds and life insurance companies may generally prefer long-term bonds that coincide with their
long-term liabilities and in maximizing their income. Commercial banks may prefer more short-term bonds
to coincide with their short-term obligations and to protect their liquidity.

However, the limitation of the theory is that some borrowers may have the flexibility to choose among
various maturity markets. Corporations that need long-term funds may initially obtain short-term
financing if they expect interest rates to decline, and investors with long-term funds may make short-term
investments if they expect interest rates to rise.

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Determining the Interest Rates

The following factors should be considered in determining the appropriate interest rate, assuming the cash
flows have already been established: (Lascano, Baron, & Cachero, 2019)
1. The interest rate in the industry;
2. Risk exposure; and
3. Compensation on market expectation.

Interest can be determined by the function of the risk and the compensation of the investor on the difference
between the risk- free rate and the market fluctuation.

𝑖 = 𝑅𝑓 + 𝐷𝑚
Where,
𝑖 is interest;
𝐷𝑚 is the debt margin or debt spread or the risk premium; and
𝑅𝑓 is the risk-free rate.

Illustrative Example:
Punzalan Merchandise plans to borrow P1,000,000 funds from Cristine Company. The risk-free rate imposed
on the loan is 5%. Cristine’s debt margin is 3%. How much interest rate should Cristine Company impose on
Punzalan Merchandise?

Solution:
Let 𝑖 = interest,
𝑅𝑓 = 5%
𝐷𝑚 = 3%

𝑖 = 𝑅𝑓 + 𝐷𝑚
𝑖 = 5% + 3%

The risk-premium is the spread between the interest rates on bonds with default risk and default-free bonds
that have the same maturity. An example of it is the difference between the interest rates of a Treasury bond
and a corporate bond. The BSP issued the Treasury Bond while a private company issues the corporate bond.
Initially, both bonds have the same attribute: identical default risk, equilibrium prices, and maturity; and the
risk premium on the corporate bond is zero (0).

If there is a possibility of an increase in default because a corporation suffers a loss, the default risk of the
corporate bond will increase. Thus, decreasing the expected return of the said bond, which will cause the
demand curve of the corporate bond to shift to the left (decrease in demand). A decrease in demand for the
bond will lower the price of the bond and thus lowering the price of the interest rate.

On the other hand, there will now be an increase in demand for Treasury bonds because it is safe to invest in
them (because again, a government cannot go bankrupt). The increase in demand will shift the demand curve
of the treasury bond to the right. With an increase in demand, there is an increase in the price of the bond,
and therefore an increase in interest rate.

The said event will eventually result in an increased spread between the default risk (corporate bond) and
default-free (Treasury bond).

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On the other hand, the risk-free rate is the rate that assumes zero default risk in the market. It is more or less
equivalent to the rates offered by the Philippines, which is usually based on the rates of the Treasury Bills
issued by them. Treasury Bills carry a zero-default risk because the government fully guarantees them, and
again, a government cannot be bankrupt. (Lascano, Baron, & Cachero, 2019)

In the Philippines, you can also base on the risk-free rate in the Philippine Dealing System (PDS) Group. PDS
Group provides full financial services from trading to clearing and settlement. It is composed of four (4)
corporations:
1. Philippine Dealing and Exchange Corp. (PDEx), which is for trading services.
2. Philippine Securities Settlement Corp. (PSSC), which is for payments and transfer services.
3. PDS Academy for Market Development Corp (PDSA, which is for training services.
4. Philippine Depository and Trust Corp. (PDTC), which is for security services.

Nominal and Real Rates

More than 70 years ago, Irving Fisher proposed a theory of interest rate determination that is still widely used
today. Fisher suggests that nominal interest payments compensate savers – the households, businesses, and
governments, in two (2) ways. (Madura, 2020)

First, they compensate them for reduced purchasing power. When the savers loan out their money, they give
up the goods and services that they could have buy from that money; thus incurring opportunity cost. To
compensate for the opportunity cost, they are paid with interest.

Second, they provide an additional premium to savers for forgoing present consumption. Savers are willing to
sacrifice consumption only if they receive a premium on their savings above the anticipated rate of inflation.
The effect of inflation on the interest rate is called the Fisher Effect. The concept can be expressed in the
following equation:

𝑅𝑓 = 𝑅𝑓𝑟 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

The equation above is the formula of a nominal rate. The nominal rate (𝑅𝑓 ) is a rate that does not adjust for
inflation. It is the rate quoted on bonds and loans. For example, if you borrow P100 at a 6% interest rate, you
can expect to pay P6 in interest without taking inflation into account.

On the other hand, the real-risk free rate ( 𝑅𝑓𝑟 ) is a rate that adjusts to the expected inflation or the purchasing
power of the Philippine Peso. It reflects the real cost of funds and the real yield to the lender or borrower. It
can be expressed in the following formula:

𝑅𝑓𝑟 = 𝑅𝑓 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

Suppose the bank loans a person P200,000 to purchase a house at a rate of 3% - the nominal interest rate not
factoring the inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%. The
real interest rate the bank is receiving is 1%. This means the purchasing power of the bank only increases by
1%.

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Illustrative Example:
Tulang Corp. plans to borrow P1,000,000 funds from Caventa Financing. The risk-free rate imposed on the
loan is 6%. Currently, the BSP announces a 2% inflation. In the following year, the monetary board expects a
1% increase in inflation. Caventa still finds that the 4% debt margin remains to be relevant. How much interest
rate should Caventa Financing impose on Tulang Corporation?

Solution:
The given 6% risk-free rate is the nominal rate. Compute for the real risk-free rate using its formula by
subtracting the current inflation rate from the nominal rate,

𝑅𝑓𝑟 = 𝑅𝑓 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
𝑅𝑓𝑟 = 6% − 2%
𝑅𝑓𝑟 = 4%

The real risk-free rate is 4%. ,

𝑅𝑓 = 𝑅𝑓𝑟 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
𝑅𝑓 = 4% + 3%
𝑅𝑓 = 7%
Then, compute the applicable interest rate or return that Caventa Financing should issue to Tulang
Corporation.

𝑖 = 𝑅𝑓 + 𝐷𝑚
𝑖 = 7% + 4%
𝑖 = 11%

Thus, the interest that Caventa should impose on Tulang Corporation is 11%. But, will this be acceptable to
Tulang Corporation? It depends on the assessment that will be made by the company. If the company assessed
that in the future, the interest would go worse than 11%, then the loan is a good offer. On the other hand, if
Tulang Corporation finds a financing company that offers lower than the 11% of Caventa Financing, then it
might reconsider.

Market Rate Interest

Another way of calculating interest rates in the market is by using the function of the market value, par value,
and the interest expense paid by debt securities, as given in the formula below: (Lascano, Baron, & Cachero,
2019)

𝑉−𝑀
𝐼+( 𝑛 )
𝑖= 𝑥 100%
𝑉+𝑀
2
Where,
𝑖 is the interest rate,
𝐼 is the periodic interest payments,
𝑉 is the par-value of bonds,
𝑀 is the market value of bonds, and
𝑛 is the term of bonds.

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Bonds Issued at Premium

A bond is issued at a premium when the market rate is lower than the nominal rate.

Illustrative Example:
Garcia Company issued bonds with a 5% nominal rate for P1,000 par value, payable for 10 years. The bonds
were sold for P1,300. How much is the interest rate of the said bond in the market?

Answer:
𝑉−𝑀
𝐼+( 𝑛 )
𝑖= 𝑥 100%
𝑉+𝑀
2

1,000 − 1,300
(1,000 )(5%) + ( )
𝑖= 10 𝑥 100%
1,000 + 1,300
2

−300
50 + ( 10 )
𝑖= 𝑥 100%
2,300
2

50 − 30
𝑖= 𝑥 100%
1150

20
𝑖= 𝑥 100%
1150

𝑖 = 1.74 %

The interest rate in the market, which is 1.74%, is lower than the nominal interest of 5%, meaning the bonds
are perceived to be riskier in the market than the nominal rate.

Bond Issued at Discount

A bond is issued at a discount when the market rate is higher than the nominal rate.

Illustrative Example:
Garcia Company issued bonds with a 5% nominal rate for P1,000 par value, payable for 10 years. The bonds
were sold for P700. How much is the interest rate of the said bond in the market?

Answer:

𝑉−𝑀
𝐼+( )
𝑖= 𝑛 𝑥 100%
𝑉+𝑀
2

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1,000 − 700
(1,000 )(5%) + ( )
𝑖= 10 𝑥 100%
1,000 + 1,300
2

300
50 + ( )
𝑖= 10 𝑥 100%
2,300
2

50 + 30
𝑖= 𝑥 100%
1150

80
𝑖= 𝑥 100%
1150

𝑖 = 6.96 %

The market rate now is 6.96%, which is higher than the nominal rate of 5%.

Mitigating the Interest Rate Risk

Various risks are inherent in every financial transaction, and these risks impose a challenge on the part of
investors. These risks include the following: (Lascano, Baron, & Cachero, 2019)
1. Default Risk – A business cannot make payments consistently.
2. Liquidity Risk – A business cannot meet its current maturing obligation.
3. Legal Risk – The lenders and borrowers cannot comply with the covenants of the contract.
4. Market Risk – The borrowers cannot settle the obligation due to market drivers.
5. Interest Rate Risk – It is the danger that the value of a bond or other fixed-income investment will
suffer as the result of a change in interest rates.

The Yield Curve

One of the risks is the interest rate risks, and the company should make reasonable estimates to mitigate it.
One way of mitigating the said risk is to determine the yield curve. The yield curve is a graphical representation
of points of rates on particular maturity date. It describes the term structure, the relationship between long-
term and short-term interest rates, for specific types of bonds such as government bonds.

The movement of the yield may be upward, inverted, and flat or constant. (Fidelity Learning Center, n.d.)
 Upward Curve – This is the usual flow of the slope, which means that the long-term interest rates are
above the short-term interest rates. This yield curve can be observed when bond investors expect the
economy to grow at a normal pace, without significant changes in the rate of inflation or major
interruptions in available credit. There are times, however, when the curve's shape deviates, signaling
potential turning points in the economy.
 Inverted Curve – This is when the long-term interest rates are below short-term interest rates. This yield
curve is often taken as a sign that the economy may soon stagnate. While this is rare, investors should
never ignore it. An inverted yield curve is often followed by economic slowdown—or an outright
recession—as well as lower interest rates along with all points of the yield curve.
 Flat or Constant Curve – This is when short and long-term interest rates are the same. Historically,
economic slowdown and lower interest rates follow a period of flattening yields.

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The movements of the yield predict the future path of interest. We can conclude that a steeply upward-sloping
yield curve indicates that short-term interest rates are predicted to rise in the future, and a downward-sloping
yield curve indicates that short-term interest rates are predicted to fall.

Upward Inverted Flat

Figure 1. The Yield Curve

Source: Fundamentals of Financial Markets 2019, p. 132

However, to effectively mitigate the risk, we need much more specific information about interest-rate
forecasts than the general information provided by the yield curve. One of the ways of doing that is by
determining and entering in the spot, forward, and swap rate. (Lascano, Baron, & Cachero, 2019)

1. Spot Rate – It is the interest rate or yield available immediately, which is equivalent to the prevailing
market rate at a particular time. Spot rate is used to mitigate the risk by referring to the historical
yield. Various factors that affect the historical yield are also identified so that if they recur, adjustments
are to be made in the current spot rate.

Example: When Typhoon Ondoy hit the country, prices of commodities in the whole Metro Manila
rose because of the scarcity of resources. The event resulted in increased interest rates. Noting the
effect on the spot rate of the said external forces, expect in the future that spot rates will increase if
the same event recurs.

2. Forward Rate – It is the rate that is guaranteed today for a transaction that will occur or be completed
in the future. The spot rate typically is used as the starting point for negotiating the forward rate.

Example: Gatdula Financing offers loans at a fixed rate of 5% for the first six (6) years. For the
succeeding years, the rate will be based on the market offering. Ocampo Company, a borrower, is
capable of servicing the debt at only 7% for the next 10 years. If it will exceed 7% interest rate, the
company will fail to maintain its debt covenant ratio. Now, it must be agreed with Gatdula Financing
to have the rates for the first six (6) years at 5% and 7% for years 7 to 10.

The risk now on the part of Ocampo Company is that if the interest rate remains to be 6% at the end
of year 10, the company will suffer a loss of 2%. However, if the market rate will result above 7%,
Ocampo will gain in the forward rate contract.

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3. Swap Rate – It is the fixed-rate exchange for a certain market rate at a certain maturity. The swap
rate is demanded by a receiver (the party that receives the fixed rate, from a payer (the party that
pays the fixed rate). The demander is compensated for the uncertainty regarding fluctuations in the
floating rate. The most commonly encountered design of interest rate swaps involves the exchange of
a fixed interest rate for the floating interest rate. The floating interest rate is typically expressed as a
value of a variable index such as LIBOR plus or minus a spread. In such a case, the fixed interest rate is
referred to as the swap/reference rate. LIBOR is calculated by using the Intercontinental Exchange
(ICE).

Example: Using the case of Gatdula Financing and Ocampo Company, where all things are held
constant, except that there is a clause in the agreement that both parties will use the prevailing market
LIBOR on years nine (9) to 10. A risk will now exist on the part of Ocampo Company when the LIBOR
is higher than the company’s servicing capability of 7%

Credit Ratings
Another driver of interest rate is the credit ratings. Credit ratings are determined by the globally -recognized
companies that objectively assign or evaluate countries and companies based on the riskiness of doing
business with them. The riskiness is primarily driven by company’s ability to manage its liquidity and solvency
in the long run. The higher the grade, the lower the default risk of the country or the company.

The three (3) major rating companies are Standard and Poor’s Corporation, Moody’s Investors Service, and
Fitch Ratings. (Lascano, Baron, & Cachero, 2019)

1. Standard and Poor’s Corporation (S&P) – It is an American financial service founded by Henry Varnum
Poor in New York in 1941. It gathers data from 128 countries using 1,500 credit analysts. The credit
rating provided by S&P were categorized to Investment Grade and Non-Investment Grade.

Category Definition
AAA The highest rating assigned by S&P Global Ratings. The obligor's capacity to meet
its financial commitments on the obligation is extremely strong.
AA The obligor's capacity to meet its financial commitments on the obligation is very
strong.
A Somewhat more susceptible to the adverse effects of changes in circumstances
and economic conditions than obligations in higher-rated categories. However,
the obligor's capacity to meet its financial commitments on the obligation is still
strong.
BBB Exhibits adequate protection parameters. However, adverse economic conditions
or changing circumstances are more likely to weaken the obligor's capacity to
meet its financial commitments on the obligation.
BB, B, Regarded as having significant speculative characteristics. BB indicates the least
CCC, CC, degree of speculation and C the highest. While such obligations will likely have
and C some quality and protective characteristics, these may be outweighed by large
uncertainties or significant exposure to adverse conditions.
BB Less vulnerable to nonpayment than other speculative issues. However, it faces
significant ongoing uncertainties or exposure to adverse business, financial, or
economic conditions that could lead to the obligor's inadequate capacity to meet
its financial commitments on the obligation.

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B More vulnerable to nonpayment than obligations rated BB, but the obligor
currently can meet its financial commitments on the obligation. Adverse business,
financial, or economic conditions will likely impair the obligor's capacity or
willingness to meet its financial commitments on the obligation.
CCC Currently vulnerable to nonpayment and is dependent upon favorable business,
financial, and economic conditions for the obligor to meet its financial
commitments on the obligation. In the event of adverse business, financial, or
economic conditions, the obligor is not likely to have the capacity to meet its
financial commitments on the obligation.
CC Currently highly vulnerable to nonpayment. It is used when a default has not yet
occurred, but S&P Global Ratings expects default to be a virtual certainty,
regardless of the anticipated time to default.
C Currently highly vulnerable to nonpayment, and the obligation is expected to have
lower relative seniority or lower ultimate recovery compared with obligations that
are rated higher.
D In default or breach of an imputed promise. For non-hybrid capital instruments, it
is used when payments on an obligation are not made on the date due, unless
S&P Global Ratings believes that such payments will be made within five (5)
business days in the absence of a stated grace period or within the earlier of the
stated grace period or 30 calendar days. It is also used upon the filing of a
bankruptcy petition or in taking of similar action. It when the default on an
obligation is a virtual certainty, for example, due to automatic stay provisions.
Table 1. Long – Term Issue Credit Ratings
Source: RatingsDirect 2014, p.6
2. Moody’s Investors Service (Moody’s) – It is a credit rating company on debt securities established in
1909 in New York, USA. It gathers information from more than 130 countries, more than 4,000 non -
corporate financial issues and financial institutions.
Category Definition
Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit
risk
Aa Obligations rated Aa are judged to be of high quality and are subject to very low
credit risk.
A Obligations rated A are considered upper-medium grade and are subject to low
credit risk
Baa Obligations rated Baa are subject to moderate credit risk. They are considered
medium-grade and as such may possess certain speculative characteristics.
Ba Obligations rated Ba are judged to have speculative elements and are subject to
substantial credit risk
B Obligations rated B are considered speculative and are subject to high credit risk
Caa Obligations rated Caa are judged to be of poor standing and are subject to very high
credit risk.
Ca Obligations rated Ca are highly speculative and are likely in, or very near, default,
with some prospect of recovery of principal and interest.
C Obligations rated C are the lowest rated and are typically in default, with little
prospect for recovery of principal or interest.
Table 2. Global Long – Term Issue Credit Ratings
Source: Rating Symbols and Definitons 2020, p.6

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3. Fitch Ratings – It was founded in 1914 in New York, USA. It is owned by the global and information
company Hearst. Fitch provides credit opinions based on credit analysis and extensive research.

Category Definition
AAA Highest credit quality
AA Very high credit quality
A High credit quality
BBB Good credit quality
BB Speculative
B Highly speculative
CCC Substantially credit risk
CC Very high levels of credit risk
C Near default
RD Restricted default
D Default
Table 3. Long – Term Issue Credit Ratings
Source: Rating Definitions, Fitch Ratings

In 2019, the Philippines was assessed by S&P at BBB with a stable outlook. Moreover, Fitch's last
evaluation was in 2017, which is also BBB with a stable outlook. Lastly, Moody’s rated the country in
2014 at Baa with a stable rating

References:

Fidelity Learning Center. (n.d.). What is a yield curve? Retrieved from Fidelity: https://www.fidelity.com/learning-
center/investment-products/fixed-income-bonds/bond-yield-curve
Fitch Ratings. (n.d.). Rating Definitions. Retrieved from Fitch Ratings: https://www.fitchratings.com/products/rating-
definitions
Lascano, M., Baron, H., & Cachero, A. (2019). Fundamentals of financial markets.
Madura, J. (2020). Financial markets and institutions. Cengage Learning.
Moody's Investors Services. (2020). Rating symbols and definitions. Retrieved from
https://www.moodys.com/sites/products/AboutMoodysRatingsAttachments/MoodysRatingSymbolsandDefini
tions.pdf
Standard and Poor's Rating Services. (2014). Ratingsdirect. Retrieved from
https://www.spratings.com/documents/20184/86966/Standard+%26+Poor%27s+Ratings+Definitions/fd2a2a9
6-be56-47b8-9ad2-390f3878d6c6

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