By Roger Goldsmith
Roger provides us with a bit of a refresher about what credit ratings actually mean and the art and science behind them.
Investors have become far more aware of credit ratings in the aftermath of the Global Financial Crisis. The real issue now for investors and advisers, is how to best use credit ratings in making investment decisions. First of all, it is important to understand what a credit rating actually is. A credit rating relates to a specific security and each rating is for that security alone.
The credit rating is based on the probability of that security defaulting. For every credit rating there is an underlying probability of default. Even AAA rated securities have a probability of default, however small. The greater the probability of default, the lower the credit rating. It is important to understand that AAA rated securities are not risk free. They have defaulted in the past and will default again in the future.
Simply put, when a credit rating agency rates a security, the probability of default is determined by the agency analysing the likelihood of the borrower being unable to meet the commitments as per the terms of the deal. The rating agency then assigns a credit rating to the security that best matches their assessed default probability. Therefore, the resulting rating represents the probability that the security will default as per the terms of the deal.
Unfortunately, the credit rating system does have some flaws. The fact that the cost of the rating is paid for by the borrower could be seen to create a conflict of interest. The borrower wants as high a rating as possible, since the higher the rating, the lower the interest rate, and therefore the lower the cost of the borrowing. In the study of Marketing, we are told that products should be designed to best suit client needs. Herein lies the potential conflict of interest for the rating agencies, in that the client’s needs are best satisfied by higher credit ratings. It is easy to imagine that most companies would prefer the rating agency that they thought would give their issue the highest rating.
We are not saying that there are credit ratings where the client has influenced the rating agency in the final rating decision. However, it is important to know that this conflict of interest does exist.
The other problem to note regarding credit ratings is that they do not take account of the credit cycle. The probability of default that forms the basis for current ratings are long term average default rates. But default rates change depending on where we are in the credit cycle.
There have been decades when there were virtually no investment grade defaults (BBB and above). However, there have been other periods where there have been large numbers of investment grade defaults, with even some AAA defaults.
As the credit cycle deteriorates, it would be expected that there are some downgrades to ratings, but credit ratings do not change sufficiently to reflect the credit cycle. More importantly, they do not reflect a rating agency’s views on future credit conditions. If credit ratings accurately reflected the current credit conditions, then the default rates for each rating would be constant over time and would not change with the cycle.
What changes to reflect the credit cycle is the credit margin that the lender receives to invest in the security. The credit margin is the reward the investor gets for buying a security over and above a risk free rate, normally that of a government issued bond. This margin is a payment for credit risk, liquidity risk and other risks such as the complexity of the issue.
It is possible to calculate the fair margin for a security based on its rating and the default rate for that rating. During buoyant economic times when defaults are low, the traded margin on a security should be less than this calculated margin. Conversely, when the economy is in recession the traded margin should be more than the fair margin.
It would not be a surprise if, during a downturn in the credit cycle, a AA rated security could be trading at the expected default rate of a BBB rated security. During these times, the market is effectively saying that although a security is rated AA, the traders think that in the current credit conditions it is more likely to have the default risk of a BBB security.
In conclusion, when making investment decisions, it is important to understand how credit ratings are derived. This will help investors understand how best to use a credit rating in the investment analysis and also its limitations.
When credit margins seem very wide relative to a security’s credit rating, it may not be that the deal represents good value. In may in fact suggest a number of other factors are relevant such as the current and future credit conditions and product complexity. Credit investment analysis needs to go beyond the security’s credit rating.