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Stock Strategist

Eleven Companies That Score Poorly on Distance to Default

We highlight one of the unique inputs to Morningstar's corporate credit ratings.

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One of the four main scores that drives the Morningstar Credit Rating is a quantitative statistic called Distance to Default. This measure's defining characteristic--and what makes it unique--is that it draws upon current market prices as a key input.

We incorporate a market-based measure into the Morningstar Credit Rating for one simple reason: Markets are often a leading indicator of financial distress. In many cases, the stock price will reflect deterioration in a company's credit strength well before it shows up in financial statements or in analyst forecasts. Incorporating a market-based measure of financial distress into our Morningstar Credit Rating provides checks and balances to our other, qualitative inputs. Based on our own backtesting, as well as a cottage industry of academic work, the algorithm underlying Distance to Default has proven a valuable and accurate detector of financial distress long before the more obvious symptoms become apparent.

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