Last week was a tough one for Exxon Mobile Corp. (XOM). The world’s largest publicly traded oil company’s profits plunged 63% in the first quarter of 2016 to the lowest level since 1999. Adding to the pressure was the decision by S&P Global Ratings (S&P), a credit rating agency, to downgrade ExxonMobil's credit rating from ‘AAA’ to ‘AA+’ because of continuing low oil price expectations. S&P’s decision to strip Exxon of its prestigious ‘AAA’ credit rating means Microsoft (MSFT) and Johnson & Johnson (JNJ) are the only two privately held U.S. companies left with ‘AAA’ credit ratings.

Exxon’s shares initially traded lower on the credit downgrade news, but later rebounded to close down only slightly lower, according to inter-day trade data from YahooFinance. The muted share price reaction leaves one wondering, what is the true value of a ‘AAA’ credit rating anyway?

Value of ‘AAA’ Credit Rating

The answer tends to lie in lower borrowing costs during times of market stress. As the chart from the St. Louis Federal Reserve Bank shows using data from Bank of America Merrill Lynch, the difference in borrowing costs can be quite noticeable during market turbulence. For example, in 2011 during the European Sovereign Debt Crisis, borrowing cost differentials between ‘AAA’ and ‘AA’ issuers peaked at about 1%. In today’s relatively calm market, the difference is closer to 0.16%.

While 1% may not seem like much, it can make a substantial difference if new borrowings are large. It is not uncommon for debt issuers to borrow large sums. For example, Apple (AAPL), rated ‘AA+’, issued $17 billion in debut dollar bonds in 2013 after things calmed down. A 1% difference in borrowing costs, however, would have been the equivalent of $170 million in annual borrowing costs. If that were over 10 years, the total amount of marginal interest would appraoch $2 billion. This is money that could be spent on research and development or returned to shareholders instead. This is just a hypothetical example, but does illustrate the material difference in borrowing costs at different times in the market cycle.

Meaning of a ‘AAA’ Credit Rating

S&P publishes a “Guide to Credit Rating Essentials”. Unfortunately, the document spends more time explaining what credit ratings aren’t instead of what they are. According to S&P, credit ratings are not backward looking, do not indicate investment merit, are not absolute measures of default probability and are not professional opinions such as those provided by doctors and lawyers.

Eventually the document discusses the meaning of S&P’s credit rating symbols, where they explain the key difference between a ‘AAA’ and ‘AA’ credit rating. According to S&P a ‘AAA’ rating indicates an “extremely strong capacity to meet financial commitments,“ while a ‘AA’ rating indicates a “very strong capacity to meet financial commitments.“ Thanks.

Luckily for those who actually rely on credit ratings, such as issuers, intermediaries and investors, there are others who provide a more comprehensive definition. Dominion Bond Rating Service Limited (DBRS), a Canadian credit rating agency, explains the difference this way, as posted by CreditGuru.

  • ‘AAA’ credit ratings, “are of the highest credit quality, with exceptionally strong protection for the timely repayment of principal and interest. Earnings are considered stable, the structure of the industry in which the entity operates is strong, and the outlook for future profitability is favourable“.

  • ‘AA’ credit ratings are “of superior credit quality and protection of interest and principal [repayment] is considered high. In many cases, [bonds rated ‘AA’] differ from bonds rated ‘AAA’ only to a small degree“.

History of ‘AAA’ Credit Ratings

Fewer and fewer companies see the benefit of maintaining a ‘AAA’ credit rating. As the chart below shows, in the 1970’s there were around 58 US corporations rated AAA, but this number has steadily declined, and today there are only two remaining.

The era of leveraged buy-outs in the 1980s and companies increasing debt on their balance sheets to improve return on equity were the main reasons that the number of companies with the highest credit rating shrank. Various economic recessions, market dislocations and technical factors have taken a toll over the years. The fact is that many Chief Financial Officers today see a higher cost in missed merger and acquisition opportunities, where higher debt levels are a necessity, than in deteriorating credit ratings and elevated borrowing costs.

Not even sovereign governments are rated ‘AAA’ anymore. For example, in 2011 the United States lost its ‘AAA’ credit rating with S&P for the first time ever. This was followed by the UK in 2013, which lost its ‘AAA’ credit rating from Moody's for the first time since 1978.

Bottom Line

Like polar ice, the ‘AAA’ credit rating is quickly disappearing from the landscape and could soon be consigned to the scrap heap of history. Treasures, CFO’s and even governments no longer see the value of having the highest credit rating possible, despite some evidence to the contrary. Maintaining investment grade ratings (above 'BBB-') seems to be what matters more in today’s world.

Disclaimer: Gary Ashton is an oil and gas financial consultant who writes for Investopedia. The observations he makes are his own and are not intended as investment advice.

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