What is a Rising Star?
A Rising Star is a business or a company that is relatively new to the debt capital markets, with little or no history of debt repayment, which makes it difficult to assess its creditworthiness. Despite the lack of history, the company’s performance is strong enough to attract a certain group of investors. However, because of a low credit rating, the company’s bonds are often considered high risk, and must, therefore, offer a premium yield.
If a rising star continues to improve its credit quality and attains the required asset ratio, its bonds will be upgraded to investment grade. At this level, it comes with a relatively low risk of default. Bonds rated somewhat higher than the usual BB – something like BBB or A3 – indicate a relatively safe investment.
Example of a Credit Rating Upgrade
Assume three-year-old Company X dealing with oil exploration discovers oil deposits in a practically unexplored country. The FAM (Financial Accountant Manager) and the board realize that their operations will be futile without substantive funding. They work to solve their financial shortfall of $1.2 billion by issuing bonds. Unfortunately, due to their low reputation in the market, their only initial option is to issue high-yield bonds that will be graded junk bonds.
The credit rating issue arises despite the company’s recent completion of the first phase of pipeline construction that catapulted it to being one of the most profitable businesses in the country and put the spotlight on a number of large investors in the company. These successes may lead to a credit rating upgrade and brand the company as a “rising star”. However, it will still have to work on establishing a more solid credit history in order to receive substantially higher ratings from the bond rating agencies.
In short, a rising star is a company that shows good potential future prospects, and that has made some progress in terms of its rating in the capital markets, but which still has work to do in order to secure the highest investment-grade ratings for its bonds.
Rising Star vs Fallen Angel
Both the rising star and fallen angel bonds may be found under the big umbrella of junk bonds. The difference is in their perceived direction. Rising stars are seen as companies moving upward toward obtaining higher credit ratings for their debt issues. In contrast, fallen angels are companies that have a longer history and previously had a higher credit rating, but that have fallen on hard times, resulting in their debt being downgraded to junk bond status.
Rising stars are seeing their credibility steadily improve, although their credit rating may remain relatively low for the moment. But they’re considered as being on track to gaining credit quality worthy of investment-grade. Thus, their bonds are typically considered less risky as compared to fallen angel bonds.
Challenges for a Rising Star
A rising star company’s most significant challenge usually lies in funding significant growth. It faces the difficulty of gaining the trust of investors, due to lack of an established credit record.
Specifically, it may face challenges such as:
- Adapting to a changing marketplace
- Adopting new strategic plans
- Cash flows and financial management complexities
Investment Opportunities with a Rising Star
It is often difficult to identify a rising star at the right stage of the market cycle. However, successfully doing so can lead to substantial returns for investors.
1 – Investors may be able to obtain the company’s bonds when they are still rated as junk bonds and therefore offer a high yield, even though the company is steadily growing and becoming less and less of a credit/default risk. An investor may then enjoy higher yields free of the correspondingly higher level of risk.
2 – As the rising star’s credit rating improves, its bonds will appreciate in value. Investors who acquired the bonds earlier, when the company had a lower credit rating, may then be able to sell the bonds for a profit in the secondary market.
Rising stars in the debt capital markets can provide good opportunities for investors. Investing wisely in rising stars requires careful research, caution, and usually patience, as it may take some time for the company’s credit ratings to significantly improve.
Thank you for reading CFI’s explanation of a Rising Star. CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ designation, a leading financial analyst certification program. To continue learning and advancing your career, these additional resources will be helpful: