Credit ratings play a very important role in modern capital markets. Since the global financial crisis, expansionary monetary policies characterised by historically low interest rates have promoted the use of debt as a viable source of long-term funding. Debt instruments are issued by various types of entities including financial institutions, commercial entities, special purpose vehicles, central or local governments, non-profit organisations, as well as sovereign countries. At a corporate level, companies planning to issue debt often need have those debt obligations rated, with investors often relying on the ratings to decide on their portfolio allocation. Sovereign ratings also help governments from emerging and developing countries to issue bonds to domestic and international investors.
A credit rating is a quantified assessment of the creditworthiness of a borrower. A short-term credit rating predicts the likelihood of the borrower defaulting within a year while a long-term credit rating reflects the likelihood of the borrower defaulting at any given time in the extended future.
Credit risks are assessed both on quantitative and qualitative considerations. It is noteworthy that many of the factors determining credit worthiness cannot be measured with precision and are inherently subjective. The competence and experience of management, resilience to changing market conditions, the effectiveness of risk control measures, among others, require a significant degree of subjective assessment.
Credit rating agencies also assess the relative credit risks of specific debt securities or structured finance instruments. The legal agreement attached to the debt, its seniority ranking vis-à-vis other classes of creditors, the underlying assets serving as collateral, are among several parameters determining the credit rating, in addition to the credit worthiness of the debt issuer itself.
Credit rating agencies
The role of credit rating agencies is to provide investors with independent evaluations and assessments of debt securities’ credit worthiness and thus encourage well-functioning capital markets. Credit rating agencies would produce financial and other research and rate the ability of borrowers to make timely principal and interest payments, and assess the likelihood of default.
Credit rating is a highly concentrated industry dominated by three big agencies which together dominate 95% of the global market. Moody’s Investors Service and Standard & Poor’s (S&P) each serve approximately 40% of the market, and Fitch Ratings around 15%. The supremacy of the Big Three is to a large extent based on first mover advantages, historical factors and the difficulty of entering the industry without a track record. The Big Three are headquartered in New York (USA) and maintain offices on all continents, rating tens of trillions of dollars in securities.
In November 2013, credit ratings organisations from Portugal, India, South Africa, Malaysia and Brazil formed a joint-venture to launch ARC Ratings, a new global agency.
Ratings methodologies differ from agency to agency and thus the ratings of one cannot necessarily be directly compared to another. Rating methodologies within each agency also evolves over time.
Credit rating scales
The relative credit risks are expressed by the Big Three through rating scales consisting of multiple letters to indicate credit worthiness. The relative risks are typically expressed through alphabetical combination of lower and uppercase letters, sometimes accompanied by pluses or minuses to fine-tune the rating.
Moody’s Investors Services assign securities with a rating from Aaa to C, with Aaa being the highest quality and lowest credit risk, and C the lowest quality, usually in default and with low likelihood of recovering principal or interest.
Standard & Poor’s rate borrowers on a scale from AAA to D. A debt issuer rated AAA has an extremely strong capacity to meet its financial commitments, while a borrower rated D has defaulted on its obligations and S&P believes that it will generally default on most or all of its obligations.
Fitch also adopts a letter system. For example, a company rated AAA is of very high quality with reliable cash flows, while a company rated D has already defaulted.
ARC Ratings rating scale consists of ‘low risk’, ‘moderate risk’, ‘high risk’ and ‘imminent or actual default’ bands.
Pricing of risks
Ratings produced by credit rating agencies may be used by lending institutions to determine the risk premium to be charged on loans and bonds. Borrowers with superior credit ratings would generally find it easier to raise funds from debt markets and at a lower interest rate.
Access to international investors
By serving as information intermediaries, credit rating agencies reduce information costs. Institutions and government entities can access credit facilities from larger pools of potential investors without having to go through lengthy evaluations by each potential lender. Lower-rated companies may still be able to sell bonds, albeit at a higher risk premium.
Ratings produced by recognized credit rating agencies would in many cases be more reliable given that those agencies would normally have access to debt issuers and their internal information, as well as to other information often not publicly available.
Liquidity of debt markets
Credit ratings facilitate the trading of debt obligations on secondary markets and by making those debt instruments more liquid, enhance their attractiveness to potential investors.
Design of structured finance products
Structured finance products are designed to take advantage of different investor risk preferences and investment time horizons, and facilitate highly customised risk-return objectives. They are often issued to raise capital at lower costs than would otherwise be the case. Pooled collections of debt instruments and other securities are split into portions, or tranches, each with varying risks, rewards and maturities to be marketed to diverse range of investors. Senior tranches would have higher ratings than junior tranches and have first lien on better quality assets.
The risks associated with structured products can be highly complex. The services of credit rating agencies would often extend, not only to the rating of structured finance products, but to advice regarding the design of those structured finance transactions so that each of the various tranches achieve their desired credit rating and appeal to the targeted investors.
Recognised credit rating agencies play an important role in the laws and regulations of several countries. Government regulations, as well as internal guidelines, often prohibit various types of institutional investors from investing in speculative bonds, or hold debt securities that are not rated at or above a certain level by a recognised credit rating agency. The use of credit ratings from recognized agencies thus provides an easy way of distinguishing between securities of different grades of creditworthiness for regulatory purposes.
From the mid-1990s until early 2003, the Big Three were the only Nationally Recognised Statistical Rating Organisations in the USA used by the US government in several regulatory areas.
Potential conflict of interest
In recent decades, the overwhelming proportion of the income of the Big Three credit rating agencies have been issuer fees, raising the issue of conflict of interest. While a bond issuer may have an incentive to seek out an agency most likely to give it a high rating, it has been claimed that credit rating agencies may also be tempted to artificially raise its rating to retain a valued customer, given the predominance of the issuer-pays model. The potential for conflict of interest is even more acute with structured finance transactions given the volume of deals and corresponding rating business attributable to specific financial institutions.
The issuer-pays business model has nonetheless proved resilient despite the potential for conflicts of interest. It has been claimed that the alternative, in the age of increased financial markets complexity and instant communication, may lead to a free rider problem. A subscription-based business model whereby credit ratings based on complex research are available only to subscribers who pay a subscription fee may be unsustainable given that those ratings can be easily and widely shared.
References to credit ratings are an integral part of all types of regulations and investment mandates. A downgrade may force borrowers out of key indices, force many existing investors to sell, slash the number of investors permitted or willing to lend, and cause funding costs to soar. In particular, credit rating changes across the investment and non-investment grade boundary often lead to sharp market price fluctuations.
Rating agencies must please a few different constituencies, including not only issuers, but also investors and investment bankers. While credit rating agencies may seek to achieve a reputation for accuracy and incisive analysis, it has been claimed that those agencies are sometimes likely to issue less accurate ratings when default probabilities are low, fee income is elevated, and the remuneration payable to top-quality analysts is high.
Following the financial crisis of 2008, credit rating agencies drew sharp criticisms for flawed methodologies and for giving high credit ratings to debts that later turned out to be high-risk investments. For instance, 73% of all mortgage backed securities rated by Moody’s as AAA in 2006 were downgraded to junk status two years later. The Financial Crisis Inquiry Commission, set up in the aftermath of the Financial Crisis, concluded that ‘the three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them.’
According to the OECD, at the end of 2019, global corporate-bond debt was $13.5trn, double the level of 2008 in real terms. Supported by a low interest rate environment, the mechanics of the credit ratings have allowed companies to increase their leverage ratios and still maintain their ratings. Still, in 2019, 51% of new investment grade bonds were rated BBB, the lowest investment grade rating, and 25% of all non-financial corporate bond issues have been non-investment grade.
Credit rating agencies, by combining both objective and subjective considerations that form a part of credit rating, provide financial market participants with an additional source of information. Businesses should understand the importance of those ratings in international capital markets, while at the same time maintain a healthy dose of scepticism.
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Fred Yeung Sik Yuen CPA FCCA CGMA MBA
Date of publication: 4th of August 2020