Stock Strategist

Introducing Morningstar's Corporate Credit Ratings

Haywood Kelly, CFA

For the most up-to-date information on our corporate credit ratings, please click here.

We're pleased to announce the launch of Morningstar's corporate credit ratings.

These new ratings describe a company's creditworthiness relative to the broader universe of corporate borrowers. The higher the grade, the more capable we think the company is of fulfilling its obligations to bondholders in a timely manner. At the top end of the range, we award AAA ratings to a handful of firms: Exxon XOM, Johnson & Johnson JNJ, and Microsoft MSFT. These wide-moat companies have impeccable balance sheets and the ability to generate copious amounts of cash. You can find a full list of our initial credit ratings here.

We're launching with credit ratings on 100 companies. In selecting the 100 companies, we took a sample of companies from our coverage list from a variety of industries and a variety of credit profiles. Most are large firms with a significant amount of bonds outstanding. During the coming months, we'll be assigning ratings to more companies, prioritizing the big bond issuers that are most relevant to bond investors. By the time we're done, we plan to rate all significant bond issuers on our coverage list, which would be up to 1,000 global companies.

All of these ratings will be available (for free) on Morningstar.com. They will appear on the quote pages after you type in a stock ticker, such as (JNJ), as well as on each company's bond summary page.

Our Approach to Rating Corporate Credit
If you're at all familiar with the way Morningstar analyzes companies, you'll recognize the key components to our credit rating methodology: the emphasis on economic moats and competitive analysis, the focus on the size and sustainability of free cash flows, and the assessment of the uncertainty surrounding a firm's operations and future profitability. In launching credit ratings, we're codifying work that we've been doing for years.

Just as our equity research methodology is forward-looking and based on fundamental company research, our credit rating methodology is prospective and focuses on our expectations of future cash flows. Our analysts build detailed models for each company they follow, and those models include five full years of forecasted proforma income statements, balance sheets, and cash-flow statements, as well as an explicit comparison of forecasted free cash flows versus debt and debt-like obligations. These models form an important underpinning to our credit ratings.

We give a detailed explanation of the mechanics of our credit rating process in our methodology documents (links to which we provide below), but we walk through the basics here.

For each company, we calculate four separate scores to help arrive at a credit rating.

  • We encapsulate our assessment of a firm's Economic Moat and other inherent business characteristics in a Business Risk Score.
  • Our Cash Flow CushionTM metric compares our projections of future cash flows to debt and other financial commitments.
  • The Solvency ScoreTM uses ratios of current financial performance that have shown a tendency to predict default before it actually occurs
  • Our Distance to Default metric uses option-pricing theory to appraise the risk that a firm's assets will turn out to be worth less than its liabilities.

Let's go through each component in more detail.

I. Business Risk
We consider seven elements in determining a firm's overall business risk, with the most weight put on the firm's Economic Moat and Uncertainty ratings.

Morningstar's Economic Moat RatingTM
The primary differentiating factor among firms is how long they can earn high returns on capital and hold competitors at bay. Only firms with economic moats � something structural in their business models that rivals cannot easily replicate � can stave off competitive forces for a prolonged period.

Uncertainty Rating
Morningstar's Uncertainty Rating represents our estimate of the predictability of future cash flows. Because equity is the residual value of a firm, it represents the cushion in the capital structure for bond holders.

Size
The larger a company's revenue base, the greater its resilience (other things equal), especially during periods of adversity. Small firms go bankrupt much more frequently than large firms.

Product/Customer Concentration
An important factor in the stability of a company's future revenues and profits is the diversification of both its product portfolio and its customer base. Other things being equal, a company with a wide variety of products sold to a variety of end markets is less subject to economic or regulatory shocks than a more-specialized company.

Stewardship Grade
Our analysts assign each company we cover a Stewardship Grade of A through F. The Stewardship Grade captures our view of a company's transparency, board independence, incentives and ownership, and investor friendliness. We feel these are key components in determining whether a company's management team is looking out for investors (whether equity or bond holders) as opposed to their own interests.

Dependence on Capital Markets
We score companies based on whether their business models require them to regularly access the capital markets. For example, a firm that must securitize assets in order to fund its operations is vulnerable to significant problems when capital markets freeze up.

Cyclicality of Operations
The greater the economic sensitivity of a firm, the more likely it is to encounter financial difficulties. We pay special attention to the sensitivity of profits to economic cycles, penalizing firms with high fixed costs that crush profitability when revenues fall.

 

II. Cash Flow CushionTM
Analyzing current and past financial statements is important, but a company's ability to meet its debt obligations can't be determined by looking in the rear-view mirror. That's where our detailed model of a company's future cash flows comes in. Our analysts create customized industry and company-specific assumptions to feed income statement, balance sheet, and cash-flow assumptions into our standardized, proprietary discounted cash flow modeling templates. We then employ scenario analysis and a variety of other analytical tools to enhance and fine-tune this process.

Our proprietary Cash Flow CushionTM gives us insight into whether a company will have the liquidity to meet its capital obligations well into the future. We make adjustments to the firm's reported operating cash flow to derive its cash available for servicing its obligations, and compare our forecasts for that cash to the company's future debt-related obligations, including interest and debt maturities.

III. Solvency ScoreTM
The Solvency ScoreTM is a ratio-based scoring system that we developed through careful analysis of historical corporate bankruptcies. We consider the ratios that are the most predictive of bankruptcy in order to assess a firm's financial strength, including the size of a company's obligations relative to its assets, and the firm's debt load relative to its cash flow. In addition to examining these ratios in past years, our analysts explicitly forecast the cash flows we think a company is likely to generate in the current year, allowing us to update ratios to reflect current events. 

IV. Distance to Default
Morningstar's quantitative Distance to Default measure ranks companies on the likelihood of financial distress. The more likely the value of a company's assets is to fall below the value of its liabilities, the greater the likelihood of financial distress. The measure treats a company's equity as a call option on the company's assets, with the total liabilities being the strike price. The Distance to Default expresses how many standard deviations separate the current value of assets from the strike price.

The Final Rating
When combined, these four factors create a ranking system for measuring an individual corporation's financial strength against that of other firms in our coverage universe. All of these factors are then reviewed by a Morningstar credit rating committee made up of senior members of the research staff, where additional adjustments to rankings may be made. The committee then decides on the final rating�AAA through C�to award the company.

Our credit ratings are issuer ratings, meaning they apply to the corporate issuer, not to any specific bond. We define the ratings, however, to apply to any senior unsecured debt of the company in question, which covers the bulk of corporate debt outstanding. Also keep in mind that a credit rating is not an investment rating�it's not our opinion on whether a company's bonds or other securities are "buys" or "sells."

But even if credit ratings do not translate directly to buy or sell recommendations, the ratings do have direct relevance for bond investors. By comparing bond issues from companies we consider to be of comparable credit quality, we can identify individual bond issues that appear potentially over- or under-priced. These investment ideas, along with weekly credit updates on our coverage list and all the underlying assumptions that go into the credit ratings, are available through our institutional service

Where to Learn More

For the most up-to-date information on our corporate credit ratings, please click here.

Haywood Kelly, CFA has a position in the following securities mentioned above: JNJ MSFT. Find out about Morningstar's editorial policies.