Thursday 31 December 2015 by FIIG Research Legacy

Credit Ratings“ A Very Basic Tool for Credit Assessment

Credit Ratings – A Very Basic Tool for Credit Assessment

A credit rating is an independent assessment of the credit worthiness of the underlying institution and gives an indication of the likelihood of default. There are many companies and systems that try to quantify risk but the three major international rating agencies are Standard & Poors (S&P), Moody’s and Fitch.

At present, Fitch seems to be the most reponsive to changes in market intelligence, downgrading, rerating, or issuing positive or negative watch statements, with the other two agencies following and often changing ratings to equate to the Fitch changes.

S&P seems to garner the title of the best in the market and Moody’s often has a more conservative approach. Over time, an analyst gets a feel for the agencies and their ratings but only ever uses credit ratings as a very basic indication of risk. Credit rating agency models are both quantitative (based on historical and forecast financial results) and qualitative (measures without numerical basis). Qualitative measures are subject to interpretation, so there is room for bias. There are other problems with ratings; for example, the decline of the monolines was well-known as was the potential impact for credit rating downgrades. Yet the rating agencies extended deadlines for recapitalisation despite breaches in quantitative limits, which suggests a certain amount of political pressure and on the flip-side a huge amount of power.

The current economic downturn has resulted in companies rated in the “A range” defaulting, which the rating agencies acknowledge can happen, although the percentage chance of an institution rated in the “A range” defaulting is low.

Lehman Brothers Holdings Inc is a good example of how quickly an institution can default and the lag in rating agency changes. Lehmans was rated A1 by Moody’s for almost five years from October 2003, then downgraded to A1 watch negative in June 2008, downgraded to A2 in July and after default the rating declined to B3 in September.

Investors often require minimum credit ratings for their portfolio, which is fine in the context of other paramaters, but if it’s is the only requirement, the investor is taking considerable risk given rating agency bias and lagging assessment. Independent research from as many sources as possbile will aid evaluation. Further, prices of debt securities may be loosely linked to credit ratings, creating opportunities for investors if they have a different assessment of the rating.

FIIG’s fixed income research team can provide indepth analysis that sometimes contradicts rating agency assessment, creating value for our clients.

Credit Rating Long Term Rating Definitions (S&P)

Long term credit ratings are forward looking assessments over a two to three year credit horizon, designed to remain stable over the course of normal business cycles. Long term ratings range from ‘AAA’ for the highest quality obligations to ‘D’ for the lowest. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a ‘+’ or ‘-’ sign to distinguish relative credit standing within each rating category.

AAA  An obligation/obligor rated ‘AAA’ has the highest rating assigned by S&P. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.

AA  An obligation/obligor rated ‘AA’ differs from the highest rated obligations only in a very small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.

 An obligation/obligor rated ‘A’ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations/obligor in the higher rated categories. However, the obligor’s capacity to meet its financial commitment on the obligation is strong.

BBB  An obligation/obligor rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to the obligor to meet its financial commitment on the obligation.

BB to C An obligation/obligor rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, or ‘C’ are regarded as having significant speculative characteristics. ‘BB’ indicates the least degree of speculation and ‘C’ the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.

Short Term Rating Definitions (S&P)

Short term credit ratings are forward looking assessments for periods of less than one year. They range from ‘A1’ for the highest quality obligation with ‘D’ the lowest. The ‘A1’ category may be modified with a plus (+) to distinguish stronger credits in that category.

A1 Strong capacity to meet financial commitments, and with a plus (+) sign indicating extremely strong capacity.

A2 Satisfactory capacity to meet financial commitments, but more susceptible to adverse changes than above.

A3 Adequate degree of protection, however adverse changes are more likely to lead to a weakened capacity to meet these obligations.

Investment Grade Ratings (S&P)

Long term credit ratings of between ‘AAA’ and ‘BBB-‘ and short term ratings of ‘A1’ to ‘A3’ are classified as investment grade.

Speculative Grade Ratings

Long term credit ratings of between ‘BB+’ to ‘D’ and short term ratings of ‘B’ to ‘D’ are speculative grade and regarded as having significant speculative characteristics.

Ratings Outlook

A Rating Outlook is assigned to all issuers with a long term credit rating and assess the potential direction of an issuer’s long term debt rating over a two to three year credit horizon.

Credit Watch

The Credit Watch status highlights an emerging situation which may materially affect the profile of a rated corporation and can be designated as ‘Positive’; ‘Developing’ or ‘Negative’; and signals to investors further analysis is being performed. However a Credit Watch does not mean a rating change is inevitable.

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