A bond refers to a financial instrument of indebtedness of an issuer to a bond holder. Companies that assess the credit worthiness of both debt securities and their issuers are called the bond rating agencies (Wellenius, 2005). In USA examples of bond rating agencies include; Standard and Poor’s, Fitch, and Moody’s agencies. Different agencies use a letter-based rating system to assist investors in assessing whether bonds carry a low or high risk and to determine the extent to which the person issuing the bond is stable or not. This essay explores the major contributions and roles of the bond rating agencies in the issuance of debt, reviews Moody’s rating agency in relation to the World Com Inc. and evaluates the ratings of the world com debt compared to other corporations in the market.
Bond rating agencies help in the analysis and evaluation of the credit worthiness of the corporate and the issuer of the debt. Therefore, the companies help to assess the interest payable of the bond (Meginson &Smart, 2009). For example, higher credit rating individuals pay relatively lower interest rates with lower risk premiums than lowly rated issuers. In addition to that, the credit ratings determine whether one is eligible for debt and other financial instruments for the investor’s portfolio. The bond rating agencies also analyses both public and private financial and accounting information about economic and political factors that may affect the ability and willingness of a government or firms to meet their current obligations efficiently.
Such companies also provide an overview used to measure the risk inherent in the financial instrument. Thus, an investor is able to assess the level of risk and compare it with expected rate of return, which he /she is capable of optimizing the risk-return trade off. According to Meggins and Smart (2009), the bond agencies provide adequate information concerning the company that is riskier to invest, thus, providing advice to any investor willing to invest in the respective company where the bonds are lowly-rated. Therefore, the responsibility of major agencies to the investment market is that it helps to reduce informational asymmetry between the investors, the lenders, issuers about the credit worthiness of corporate institutions.
From the given financial information of World Com Inc., it is possible to compute its financial ratio, debt to total assets, current ratio and return on assets. According to Moody’s Bond Rating Definitions, based on debt/total asset ratio, the bond rating is Baa2, in the year 1996, Ba1 in 1997 and B2 in 1994 and C1, in 1995, which is the analysis of debt to assets. The same ratings will be applicable when current ratio is selected. The current ratio measures the ability of the company to pay its liability. For instance, the ratings Baa, would apply in 1996 with a good current ratio of 1.2 but a relatively lower return on net assets of -1.1%.
Therefore, it implies that despite the current asset being able to offset the current liabilities, the return is lowest and thus it is risky for the company because getting positive return would not be possible. In 1997 the debt /total assets is 39.7%, the current ratio is 0.8 and the return on asset is 1.7%. It shows that the return is lower despite having a considerably fair current ratio, therefore, the rating would be Ba.
The factors contributing to the difference in ratings is the change of prospects of default by a significant amount (rating through a cycle) and not changes in the short-run credit risk (rating at a point in time). Another factor is the contract between the firm and investor, for example a contract to pay more quickly and increase collateral thereby raising the cost of financial instruments. Moreover, the existence of other external support such as guarantees, insurance and collateral would reduce the impact of risk.
World com purchased MCI Corporation. for $ 37 billion in November 1996. Through acquisition MCI, World com’s revenue was more than $30 billion in 1998 and it agreed to pay BT $6.94, which was equivalent to 20% stake in MCI Corporation. MCI generated $1.75billion through the sale of internet business cable before World com agreed to get credit from a bank, which constituted a $5 billion term loan due in 2002 and $7 billion to be renewed two years later. World com spent $2.5 bllion yearly to improve its infrastructure, to pay BT, and thereafter, the bank using bonds in four tranches.
Based on the financial information available in exhibit 3 of the case study, there is evidence that World com did not follow an appropriate financial strategy. This is because the interest payable on the bonds would be higher. Moreover, it is not feasible as the financial information from the previous year ($44million) could not be compared to the total cost incurred in acquiring MCI Corporation despite the company viewing that their rating would be high. It is misleading in terms of the borrowing cost and interest to be paid by world com.
References
Meginson, W. L., & Smart, S. B. (2009). Introduction to corporate finance. Mason, Ohio: South-Western Cengage.
Wellenius, B. (2005). Implementing reforms in the telecommunications sector: Lessons from experience. Washington, D.C. Learning.