Credit migration risk is downgrade risk in the credit rating for a company or (bond) issuer. Investors can use credit migration to determine if a company’s credit is getting better or worse. In this article, we’ll explain what credit migration risk is and how to incorporate it into investment analysis.
What Are Credit Ratings?
Most public companies have a credit rating. These ratings are provided by established credit rating firms such as Moody's, S&P Global, and Fitch Ratings. Credit ratings for public companies are similar to credit scores for individuals. The higher the number or letter for credit ratings, the lower the company’s credit risk.
Investors use credit ratings to determine if a company is worth investing in or how much risk they might be taking on by investing in the company. Lenders also use credit ratings to set loan interest rates and terms. Lenders also use a credit rating to determine if a company is too risky for lending.
Companies with low credit ratings will get the worst lending terms. In addition to higher interest rates, they may have stricter loan covenants than companies with better credit ratings.
Besides lending, companies will issue bonds to raise cash. Companies with lower credit ratings pay the highest interest rates on debt (i.e., bonds), creating a higher debt service. Higher debt costs can limit a company’s ability to raise cash and thus grow.
Credit ratings for some companies can drop enough that they fall into a non-investment grade category. Non-investment grade means certain institutional investors will not invest in these companies or buy their bonds. Bonds from these companies are referred to as junk bonds.
What Is Credit Migration?
Lenders and some credit rating firms categorize and monitor credit ratings. For example, some lenders might split credit ratings into three categories:
- Low risk
- Medium risk
- High risk
Over time, companies may move between these categories as their credit ratings change. This change in credit ratings is called credit migration because a company is moving or migrating from one level of rating to another. While the above example is very simple, the three categories will go into a credit migration table.
Monitoring credit migrations provides lenders with trends. For example, Company A's credit may have slowly degraded over several years. A quick glance at a credit migration table will reveal this information without the need for time-consuming analysis.
When a company's credit rating decreases and descends to a lower credit level, this is called negative credit migration. Positive credit migration is just the opposite.
Credit Migration Risk And Real Estate
What role does credit migration risk play in real estate investing? For investors who invest in large CRE companies, monitoring their credit migration is important to understanding if the company’s credit is getting better, worse, or remaining fairly static. The same can be said for publicly traded REITs 1 and real estate companies.
DST investors may find that an understanding of credit migration risks is useful to them as well. For example, DST sponsors often take on debt to purchase properties. The credit rating of these sponsors will determine their loan interest rate, which impacts investor returns.
As many DST sponsors are private companies, it can be difficult to know their credit rating, assuming they even have one. Given this lack of data, investors will need to dig in and ask questions about the sponsor's creditworthiness or the interest rate on the debt that the DST has assumed.
1. A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
2. There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence
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