Credit Ratings

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Credit Ratings
by David Wyss

Executive Summary
• • • A credit rating is an opinion from a credit rating agency about the creditworthiness of an issuer or the credit quality of a particular debt instrument. Primarily, the rating opinion considers how likely the issuer of the debt instrument is to meet its stated obligations, and whether investors will receive the payments they were promised. A failure to meet such payments may be considered a default.

Introduction
There are three major international rating agencies in the United States: Standard & Poor’s Ratings Services (a unit of The McGraw-Hill Companies), Moody’s Investors Service, and Fitch Ratings (a unit of Fimalac SA). In addition, there are many regional and niche rating agencies that tend to specialize in a geographical region or industry. The major agencies state that their opinions of the credit quality of securities are based on established, consistently applied, and transparent ratings criteria. Although the agencies use different criteria, definitions, and rating scales, they each state a view on the probability that an entity or security will default. Some rating agencies also assess the potential for recovery—how likely the investors are to recoup their investment in the event of default. Issuers of most fixed-income securities issued in world financial markets request and receive a credit rating from a rating agency. Although credit rating evaluations are not always required, they may increase the marketability of a debt instrument by providing investors with an independent opinion about the instrument’s relative credit quality.

Why Do Corporations Request a Credit Rating?
A credit rating opinion is often required by investors before they purchase securities. Many investors want to see an established opinion about the credit quality of a security that is not from the issuer or underwriter. In addition, some funds have made it a requirement for their investment guidelines or as part of what they have promised their investors. Issuers who are not well known or who are trying to sell into international markets may benefit from a rating from a recognized rating agency. The rating provides market participants with an opinion on the credit quality of a particular investment. Ratings from the major credit rating agencies have a strong track record, as reported in their default and transition studies. Over the long run, securities with a higher credit rating have consistently had lower default rates than securities with lower ratings. Ratings are just opinions, however, and there have been certain periods when highly rated securities in a specific sector ultimately performed worse than other securities rated in the same category. Accordingly, ratings do not remove the need for the investor to understand what he or she is buying. The Standard & Poor’s rating scale is a simple and easy-to-understand shorthand for its credit opinions. A more detailed analysis is typically available from Standard & Poor’s, including the rationale behind the rating opinion. Investors are encouraged to read the detailed analysis carefully to understand why an agency assigned a particular rating. Having a rating may be useful even if a corporation elects to raise money privately rather than through a public bond issue. Obtaining a rating may make it easier for a company to seek funding from a private lender or bank. Although not every company needs a credit rating, most medium-sized or larger firms find it useful.

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How a Rating Is Assigned
Credit rating agencies assign ratings to issuers, including corporations and governments, of debt securities, as well as to individual issues such as bonds, notes, commercial paper, and structured finance instruments. The agencies rate an issuer by analyzing the borrower’s ability and willingness to repay its obligations in accordance with their terms. The agency’s analysts consider a broad range of business and financial risks that may interfere with prompt and full payment. Most rating agencies use a mix of quantitative and qualitative analysis. Typically, analysts who consider qualitative factors contact management at the firm being rated to obtain additional information that may help them to arrive at an informed opinion. In some cases, they will ask for information that is not available to the general public, such as details of business plans, strategies, and forecasts. Agencies generally also examine the company’s audited financial reports to analyze credit strengths and weaknesses. A rating can apply to an individual issue, although the issuer may also be assigned an underlying rating based on its overall financial strength. An individual issue is usually given an evaluation based on information provided by the issuer or obtained from other reliable sources. Key considerations include: • • • the issue’s legal structure, including terms and conditions; the seniority of the issue relative to the other debt of the issuer; the existence of external support or credit enhancements, such as letters of credit, guarantees, insurance, and collateral—which are protections that are designed to limit the potential credit risk.

When an issuer requests a rating, it generally supplies the rating agency with its audited financial statements. In most cases, the rating agency will also meet with the issuer to discuss any questions that the agency may have and to learn about any business plans or other factors considered to be important. Frequent issuers will often have a longer-term contractual relationship with the rating agency that may include rating all new debt issues. Credit ratings from the major rating agencies are normally paid for by the issuer of the securities, and are made public immediately thereafter, although in some cases issuers or investors may request a “private” rating on a security. When ratings are requested by parties other than the issuer, and without direct access to the issuer for questioning, they are usually marked as “public information” or given similar subscripting by the rating agency. The issuer-pays model has two hallmarks: First, the major rating agencies make ratings public (and if they didn’t, that news would quickly become public), so it is hard to get investors to pay for what they can get for free on the news. Second, issuing a rating often involves access to the company’s confidential data, which is not permissible under a subscriber-pays model. In some circumstances, most agencies will rate some securities without any consultation with the issuing firm. In these cases the ratings are based only on public data, and are normally indicated as such. Ratings are generally published at the time they are issued. However, sometimes a private rating may be issued for an individual investor or group of investors, usually for a security that is not intended for public trading. Many firms want a confidential rating for management purposes and as a second opinion on the credit quality of a loan. Ratings are not static, and rating opinions can change (or transition) if the credit quality changes in ways that were not expected at the time the security was issued. Ratings may be reviewed and updated on a regular basis, or when a significant change occurs in the performance of the issuer, the markets, or the economy. The acquisition or divestiture of a company, a political threat to (or from) the government, or erosion in the economy or credit markets can cause a rating to be adjusted. Normally, warning of a likely change is provided through an “outlook” or “credit watch” that states the direction in which a rating may move. However, sometimes a sudden deterioration may force a shift in a rating with little warning.

Rating Scale
Each credit rating agency uses its own criteria and methodology to evaluate creditworthiness. The process may be predominantly quantitative or qualitative, but is usually a blend of the two. Once an agency completes the analysis, it issues a rating based on its own scale. Ratings are typically expressed as a grade, such as AAA, BB, or CC, with AAA (or equivalent) denoting the strongest and D (or its equivalent) the
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weakest (i.e. that a default has already occurred). Note that the rating scale for short-term instruments such as commercial paper is different from the long-term scale. For example, at S&P the top long-term rating is AAA, while the highest short-term credit rating is A-1+. D stands for default in both scales. Although a rating scale is relatively straightforward, the assumptions, considerations, and judgments behind the opinions can be complex. Most agencies explain their rationale in published documents that may be read by investors. Among others, the risk factors include the financial performance of the firm, the characteristics of the economy and industry it operates, and the quality of its management. Standard & Poor’s credit ratings strive to be forward-looking, focusing not just on the past but also on the likely future state of the industry and the firm. Standard & Poor’s ratings are intended to be consistent across all issuers and debt instruments. Over the very long term, all instruments with the same (say, A) rating are expected to have similar default experience. However, the short-term behavior of these instruments may be very different. Different industries respond differently to economic and credit cycles. Credit ratings are not exact measures of the default probability of an issue or issuer, but an opinion about relative credit risk. In assigning ratings, agencies rank relative credit risk from strongest to weakest, based on relative creditworthiness and credit quality within the rated universe. Actual default probabilities may change over time.

Recovery
Some credit rating agencies incorporate the potential for recovery into their opinions, while others may give a recovery rating that is separate from the credit rating. Recovery prospects after default are an important component in evaluating credit quality, particularly in evaluating more risky debt issues.

Islamic Credit
Mounting demand for shariah-compliant financial products and services has fueled the rapid expansion of the Islamic banking industry. More and more banking clients are choosing to invest in a broadening range of Islamic financial instruments (IFI) through long-established banks in the Gulf Cooperation Council (GCC) and Malaysia. The model has spread beyond the Gulf to the Maghreb and Muslim Asia, as well as to Muslims in predominantly non-Muslim countries in the West, Asia, and Africa. Demand for shariah-compliant instruments has risen sharply as a result of strong economic growth within the Islamic world and the large surpluses of the oil-producing countries. The volume of shariah-compliant instruments outstanding is estimated at over $500 billion, with sukuk (an Islamic financial certificate) issuance reaching $100 billion. Islamic banks have focused on the retail segment in the Arab world and Malaysia but are expanding to other countries. North Africa has been a recent region of strong growth, with Tunisia and Morocco authorizing Islamic banks for the first time in 2007. The central bank of Morocco became a shareholder in the International Financial Services Board (based in Malaysia), which serves as a transnational regulatory body to harmonize regulation and supervision for Islamic banks. Islamic securities such as sukuk are rated by agencies employing the same fundamental analysis as are used for rating other issues. The rating provided does not, however, express an opinion regarding the shariah compliance of any Islamic financing instrument, institution, or debt issue. It is the responsibility of the shariah board of the originating institution to rule on compliance with Islamic law. The agency rates the security based on its analysis of the willingness and ability of the issuer to make the agreed payments, as specified in the security.

Ratings and Investment
Although credit quality is an important element in an investment decision, it is not the only or even the most important element. Ratings opinions are not investment recommendations. In making any investment, the investor should consider the trade-off between risk and reward. Credit quality is only a partial measure of one of those trade-offs.
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A security’s price is generally one of the most important considerations for an investor. If the price is low enough, almost any investment becomes desirable; if the price is too high, any investment becomes unattractive. The price determines the long-run return on the investment, assuming that it pays as scheduled. As a minimum, three other factors besides price and credit quality should be considered. First, what is the downside risk or likely recovery if the security defaults? Second, what is the liquidity of the investment—how easy is it to sell if it must be disposed of before its maturity date, and how responsive is pricing to changes in interest rates or the market environment? An important issue for investors buying outside their home country is the potential for exchange rate change or government interference with the ability to collect payment. Fortunately, foreign exchange controls have become very rare outside of a few very weak emerging economies, but foreign exchange risk is very real. The US dollar/euro exchange rate went up 20% in early 2008 and then down 20% over the next three months.

Conclusion
Credit ratings may be used by investors and other market participants in making investment and business decisions that are aligned with their risk tolerance or credit risk guidelines. Credit ratings are opinions about the perceived credit risk of a particular debt issue. In general, the greater the credit risk, the higher the return investors may expect for assuming that risk. For that reason, credit ratings may be useful for both issuers and investors when a debt issue is first issued in the primary markets and continues to be so for investors who trade securities in secondary markets.

Making It Happen
• • • • Ratings can be obtained from a variety of agencies. Consider who will be your likely investors before deciding to go with a global or a local rating agency. Have your financial and business plans in order and fully audited by a reputable firm before trying to get a rating. Ratings are opinions about credit risk, and not investment advice or opinions on pricing. Work with your banker on determining which agency to use and whether a rating is desirable.

More Info
Books:
• • • • Duffie, Darrell, and Kenneth Singleton. Credit Risk: Pricing, Measurement, and Management. Princeton, NJ: Princeton University Press, 2003. Fuchita, Yasuyuki, and Robert E. Litan (eds). Financial Gatekeepers: Can They Protect Investors? Baltimore, MD: Brookings Institution, 2006. Langohr, Herwig M., and Patricia T. Langohr. The Rating Agencies and Their Credit Ratings: What They Are, How They Work, and Why They Are Relevant. Chichester, UK: Wiley, 2008. Levich, Richard M., Giovanni Majnoni, and Carmen Reinhart (eds). Ratings, Rating Agencies and the Global Financial System. Norwell, MA: Kluwer Academic, 2002.

Article:
• Cantor, Richard. “An introduction to recent research on credit ratings.” Journal of Banking & Finance 28:11 (2004): 2565–2573.

Websites:
• The main sources of information on ratings are the websites of the three major rating agencies: www.moodys.com, www.standardandpoors.com, and www.fitchratings.com. A good discussion of ratings trends is found in the “Guide to credit rating essentials” produced by Standard & Poor’s (2008, 20 pages): www2.standardandpoors.com/spf/pdf/fixedincome/SP_CreditRatingsGuide.pdf
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Credit Ratings

See Also
Best Practice • Investing in Structured Finance Products in the Debt Money Markets • Minimizing Credit Risk Checklists • • • The Bond Market: Its Structure and Function How to Manage Your Credit Rating How to Use Credit Rating Agencies

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http://www.qfinance.com/raising-finance-best-practice/credit-ratings?full

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