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Financing Best Practice

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.

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.

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Further reading

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.

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