LocationsUnderstanding Credit Ratings: The Basics
Understanding Credit Ratings: The Basics
Credit ratings are consistently promoted as being complex calculations based on secret and convoluted processes. However, there are a variety of basic elements which provide a solid and broad understanding of what the ratings are, how they are devised, why they are devised, and how they are used. The following are some inherent factors that are important to know when seeking to understand the world of credit ratings:
Credit rating agencies are particularly careful to label their ratings as ‘opinions’, with the legal language attached to a rating telling users not to rely on the ratings. This is important because it protects the credit rating agency from liability, should their ‘opinion’ prove to be wrong. As credit rating agencies are in the business of predicting, there is a natural limitation to the accuracy of what they can offer. The opinions of rating agencies are displayed via rating scales which mask the complexity of the opinion underneath.
Whilst the effect of a credit rating may feel like a judgment on a company or country’s character, history, or existence, it is not. It utilises those elements to decide on one simple question: what is the likelihood of a creditor receiving their investment back on time, and in full. The credit rating agency is not concerned with anything more than that equation. Though their ratings are purchased by the issuers of debt, the credit rating agencies exist to serve the private investor.
A credit rating agency offers two distinct products (not counting any consultancy services). They offer a rating on the issuer which rates the issuer of debt as a whole regardless of any particular instrument. The other product is a instrument rating, where a particular debt instrument like a bond will be rated. The rating’s purpose is to provide an opinion on the ability of the issuer to meet the terms of that particular security and the terms attached to it.
A credit rating agency must, within the same rating, look backward and forward. It must consider the history of the issuer, in order to present a judgment on the future. In order to do this, the rating agency will usually have a timeframe in mind for each endeavour. For looking backward at aspects such as default history, a rating agency will usually look back as far as 10 years (sometimes 5).
Looking forward, the credit rating agency will rarely look further than 3 years, and this is for good reason: the longer the time horizon is looking forward, the more difficult it is to predict what will happen. Short-term ratings can be developed which will usually only look a year into the future, whereas a normal credit rating reaches its limit at 3 years.
Ratings can be produced for particular instruments which have very short maturities, like commercial paper, but this usually does not concern sovereign issuers.
The terms ‘investment grade’ and ‘non-investment grade’ are common parlance, but understanding the difference and the implications is important. When you look at the rating scale (available in this Portal) you will see a demarcation in the centre of the scale. This is the separation between the two. This has a demonstrable effect because it is the line at which most investors are constrained, either by their own mandates, their principals, or by the regulations surrounding them. For example, a lot of systemically important financial institutions are mandated to only invest in issuers or instruments that are deemed ‘investment-grade’. There is a phenomenon known as the ‘cliff-edge’ for issuers who move past the line into non-investment grade, as they usually suffer a sever sell-off from investors who technically or legally can no longer hold their debt. Debt traded below the line usually has to have an increased interest rate attached to it in order to compensate for the increased risk intimated by the new rating.
Rating ‘outlooks’ and ‘creditwatches’ are ways in which the credit rating agency fine tunes the rating, or adds granular identifiers to the rating in order to provide even more information (or warning) to investors. By definition, a ‘stable’ outlook means that the rating of the sovereign is not expected to change over the medium term (0.5 years to 2 years). This is supported by research that shows, for example with Moody’s, that ratings given a stable outlook do not change for a year in 90% of cases. The relative difference between a positive outlook and a negative outlook being attached has been analysed and a country is more likely to receive an upgrade after a positive outlook than a downgrade after a negative outlook; either way, the positive/negative outlooks are important indicators of forthcoming action so an issuer must be acutely aware of the implications of both.
Because of the unique nature of the sovereign issuer (as explained next), a sovereign credit rating is also unique. For a corporate issuer, everything is on the table but for a sovereign issuer, only their relationship with the private creditor is on the table. This means that the issuance of so-called ‘Eurobonds’ (named because they are in a foreign currency) is the sole focus because they are invested in by private creditors. The sovereign’s relationship with multilateral institutions like the IMF, or bilateral creditors like other countries, is rarely of relevance (unless there are key signals coming, like persistent default). This is a key issue in relation to debt treatment initiatives that insist on ‘comparable treatment’ because in order for that to take place, private creditors must face a prospective loss on their contracted agreement – this is always seen as a default-potential and thus factored into the ratings, usually down to ‘default’.
The biggest element when rating a sovereign issuer is its ‘willingness to repay’. This is a unique factor because, in the corporate world, there is no such concept. A corporate issuer can be compelled by law to repay, or face being liquidated in order to settle debts. There is no such authority over sovereign states, and a sovereign state cannot be ‘liquidated’ to pay off its debts. Therefore, factoring in the country’s capacity and willingness to repay its debt is the central question facing a credit rating agency when analysing sovereign issuers. This is why qualitative-related data is vital, like the strength of the political institutions within a sovereign, and the rule of law. It is also why past defaults can be critically harmful for a sovereign because it indicates an experience of nor repaying debts.
There are some basic expectations of a credit rating agency and their ratings which provide important context. There are three main expectations, in that they should 1. Be accurate predictors of defaults, 2. timely, and 3. as far as possible, stable. When any of those three are not witnessed, we usually see crisis. However, there are trade-offs which make this simplistic understanding merely a model to follow. For example, there is a trade-off between stability and timeliness which cannot be resolved: if a rating is to be timely, it may need to be ‘volatile’ in terms of its frequency, especially in a time of market upheaval. This then leads to claims of procyclicality, which is a common complaint of the credit rating sector. In order to maintain stability, credit rating agencies apply a particular approach labelled the ‘TTC’, or ‘Through the Cycle’ approach which intends to capture the entire business cycle. The rating agency then uses its methodology to smooth out this approach, but it is often beset by external influences which could negatively affect its usage.
The Evolution of the Credit Rating Agencies
