Jonathan Rochford

With the potential for a downgrade in the credit rating of Australia, and the recent downgrade of the United Kingdom there’s been a spike in interest in credit rating opinions. While many speak of the desire for Australia to retain the coveted “AAA” rating few understand what actually goes into a credit rating. The financial industry relies heavily on the opinions of credit rating agencies, but are rating agencies providing the high-quality analysis that everyone assumes? In the article below I look at some of the criticisms levelled at ratings agencies, and the merits of ratings for different types of debt.

The basics of a credit rating

Credit ratings are an opinion of the financial strength of a debt issuer. The letter combinations often cited (i.e. AAA or BBB) denotes the relative ability of an issuer to repay its principal and interest on time. The table below from Standard & Poor’s explains their view of financial strength.

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Source: Standard and Poor’s

Credit ratings are a mix of qualitative and quantitative factors. The primary driver of a rating is a combination of financial ratios such as debt/EBITDA for corporates or debt/GDP for governments. Analysts overlay a qualitative adjustment to the ratios which can result in a slightly higher or slightly lower outcome than the ratios alone would indicate. The entire process is subjective; what ratios are used, in what proportion they are weighted and the qualitative adjustments are all components that issuers argue about seeking to influence the ratings agencies to issue a more positive assessment of their debt repayment prospects.

What a rating says about a debt issuer

The opinions of ratings agencies are seen as important by investors as a lower rating indicates a higher risk of principal and interest not being paid in full. The chart below shows that companies with lower ratings have an exponentially higher probability of defaulting on their debts. As a result, debt issuers with lower ratings must pay a higher interest rate in order to attract buyers for their debt to offset the perception they have a higher risk of not paying their debts. 

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Source: Standard and Poor’s

Criticisms of Rating Agencies

Conflicts of interest

The big three rating agencies (Standard & Poor’s, Moody’s and Fitch) have attracted heavy criticism from governments, regulators and investors as they charge both issuers and investors for their services. Issuers pay the rating agencies to prepare a report and provide an opinion on their risk profile. This creates tension between issuers and rating agencies, as the issuer can threaten not to pay the rating agency if the opinion is not optimistic enough for their liking. Investors pay rating agencies to be able to access the detailed reports, though rating agencies do make the ratings publicly available without charging. As a result of this conflict of interest independent credit research firms such as CreditSights and Egan-Jones have emerged that are paid only by investors for their analysis. 

Ratings are not fungible

One of the biggest misunderstandings of credit ratings is that the same risk rating for different types of debt (e.g. corporate, sovereign, financial institution) means they have equal likelihood of defaulting.  As history has shown many times, different types of debt have very different risk profiles for the same rating. It is reasonable to compare ratings within the same debt type, but erroneous to compare ratings between debt types. This is explained further in the following section on the merits of ratings for different debt types.

Ratings changes are delayed

Investors have long complained that rating agencies fail to downgrade ratings in a timely fashion. Many prefer credit default swaps as a better measure of the real time probability of default, although these have a tendency to overshoot when negative information comes to light. Rating agencies often give the benefit of the doubt to debt issuers as downgrading a rating is typically a controversial step that the issuer may publicly disagree with. In the most fractious cases, issuers stop paying the rating agency and ask for the opinion to be withdrawn.  

Performance in the financial crisis

The poor track record of credit ratings during the financial crisis means that the big three credit ratings agencies aren’t trusted anywhere near as much as they used to be. Lehman Brothers had “A” ratings when it defaulted and many other failing banks were similarly rated. Thousands of ratings and trillions of dollars of debt were downgraded across mortgage backed securities and collateralised debt obligations from 2007 onwards. In the worst examples, securities went from AAA to defaulting within a year. Investors who failed to undertake their own due diligence suffered substantial losses and many took legal action as a result.

The Merits of Ratings for Different Debt Types

Corporate debt

Ratings on corporate debt are the bread and butter of rating agencies and it is where they do their best work. Thousands of companies are publicly rated with Moody’s data set stretching back to 1920. The big three rating agencies produce annual reports which show that lower rated corporates are far more likely to default than higher rated corporates. On the whole, there are few examples of highly rated corporates defaulting with Enron and Parmalat arguably the worst in recent decades. Both of these involved financial deception on the part of management. The main criticism of corporate debt ratings is the slowness of downgrades as companies deteriorate. Investors can generally expect corporate credit ratings to be an approximately fair reflection of default risk.

Sovereign debt

Rating agencies are almost always too optimistic on their ratings for developed nations. The standout example is Japan, with the big three all seeing it in the “A” category. Most independent analysis of Japan has it unable to repay its debt without printing money. If the average interest rate on its debt was to rise by 3% all government revenues would be consumed by interest payments with nothing left for healthcare, education or defence spending. Many governments in Europe and the US continue to receive high ratings even though they are running substantial budget deficits year after year and have sizeable unfunded pension obligations. Ratings for developing nations tend to be a fairer reflection of their risk of defaulting. Investors should treat sovereign debt ratings with great caution.

Financial institutions debt

Rating agencies tend to be way too optimistic in rating large banks and somewhat less optimistic in their opinions of smaller banks. For large banks, credit ratings have a substantial impact on their ability to attract institutional funding and to trade with their counterparties. A downgrade below investment grade (below BBB-) is effectively a death knell. AIG and Lehman Brothers were examples of hugely optimistic ratings during 2008. Comparisons are now being made between Lehman Brothers and Deutsche Bank, which could see its funding and trading opportunities rapidly disappear if it suffers further downgrades. Several Italian banks are being talked about as needing government bailouts yet still have credit ratings in the “B” and “BB” categories. Investors should treat credit ratings of financial institutions with great caution.

Securitised debt

Rating agencies were rightly excoriated for their ratings of securitised debt such as mortgage backed securities and collateralised debt obligations in the lead up to the financial crisis. As highlighted in the move The Big Short, rating agencies gave inflated ratings to securitised debt in order to protect their market share and maximise revenues. However, since the financial crisis the rating agencies have dramatically increased their analysis of securitised debt to the point where the ratings are generally pessimistic. In a reverse of the situation for other types of debt, rating agencies are criticised for failing to upgrade ratings in a timely fashion when securitised transactions perform in line or better than expected. Investors can generally expect securitised debt credit ratings to be an approximately fair reflection of default risk, but need to bear in mind the diversity within securitised debt and the range of complex assumptions required to produce a rating.

Conclusion

Credit ratings play an important part in the functioning of capital markets, but should always be treated as an opinion not a definitive judgement. Issues with credit ratings include the conflicts of interest that the big three rating agencies have, ratings are not fungible between debt types and rating agencies tend to be slow to downgrade ratings in response to new developments. Credit ratings for sovereign and financial institution debt tends to be particularly optimistic but corporate debt and securitised debt are generally more reasonable assessments. Investors should always conduct their own financial analysis and form their own judgement before investing.

Written by Jonathan Rochford for Narrow Road Capital on July 6, 2016.  (VIEW LINK)



Comments

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Bruce Bargon

Thank you, a useful, informative explanation.

Emma Davidson

Very good piece, very informative. I like the comparison between ratings agencies being reactive and the CDS being over-reactive. Using a combination of both is probably best, the issue is the freedom of this information.