Investing In Investment Grade Credit : Improved credit rating?
The financial crisis threw the spotlight on rating agencies. In particular, the failures in sub-prime asset-backed securities (ABS) that were seen as the catalyst that unleashed the global maelstrom of 2007-09 called into question their methodologies for rating structured products.
But the same cannot really be said for corporate credits, whether financial or non-financial.
“Corporate bond ratings have not seen anywhere near the drop in credibility that occurred in structured product ratings,” says Scott Weiner, managing principal at Payden & Rygel. “With rare exceptions – Lehman Brothers, Washington Mutual – investors were paid back their principal in full for investment-grade-rated credits during the crisis. For structured products, investors were getting paid 90, 80, 70 and in many cases, close to zero cents in the dollar.”
There are still lessons that have been learnt from the financial crisis, and the major rating agencies have made changes to their frameworks for corporate credit assessments, in addition to the more widely publicised issues concerning structured products.
One profound change that has occurred is in the way all market participants treat the nature of a rating. The pre-crisis attitude of many market participants – which often verged on treating rating agencies as though they were infallible – has been replaced by concerted pressure to force users of ratings to understand their limitations.This pressure is being exerted through regulation of the agencies themselves.
“Ratings are forward-looking statements about the likelihood of a default, but they are opinions based on a set of assumptions about what may happen in the future,” says Michelle Brennan, criteria officer for the financial services sector at Standard & Poor’s.
“Credit rating agencies have moved from being lightly regulated to heavily regulated and, as a result, we have become a lot more transparent in the way we communicate the underlying corporate methodology to investors, bankers or other users of ratings,” says Michael Dunning, EMEA head of corporate ratings at Fitch.
In 2013, S&P published a paper outlining new and significantly enhanced corporate criteria.
“The new criteria were all about enhancing the transparency of what we do,” says Peter Kernan, S&P’s criteria officer for non-financial corporates. “All users of ratings can now see very clearly what key risk factors are considered in our methodology and how changes to those risk factors can potentially affect the ratings.”
The rating process, though, is never purely based on a set of algorithms applied to numerical data. Ultimately, the final decisions on rating changes are always made by a rating committee that uses its own judgements.
“We embedded within the criteria a very forward-looking bias,” says Kernan. “There is significant analytical judgement within the ratings process, so the criteria is a mix of quantitative and qualitative risk analysis together with many instances where our analysts make judgement calls based on their significant sector and country experience.”
This sort of approach makes dialogue between rating agencies and their users important – a fact increasingly both acknowledged and encouraged.
Fitch publishes forecasts for the principal determinants of the rating for each individual issuer and continues to evolve its product.
“In 2015, we plan to launch an interactive model that will allow users to input their own views and expectations, assess how they compare with the key assumptions in our model, and enter into a dialogue with the analyst as to what we see as the key factors,” says Dunning.
Economic and industry risk
While the criteria for ratings in the non-financial corporate sector have not changed, it would be surprising if a global crisis originating in the financial sector had not led to some changes in the analysis of that sectors’ creditworthiness.
“Whilst there were very few bank defaults during the crisis, when we looked at the rating performance, it was more volatile than it had been historically,” Brennan acknowledges.
Detailed reviews of methodology have led to a greater emphasis on the macroeconomic backdrop, leading, at S&P, to the development of its ‘banking industry country risk assessment’ (BICRA).
“If you analyse banks by just looking at their financial reports, you may find that a bank’s financial statements will look very, very good up to the point at which they don’t,” says Brennan, ruefully.
The BICRA methodology attempts to produce forward-looking analysis through two components – an assessment of ‘economic risk’ and ‘industry risk’ (which look at factors such as industry concentrations) in each jurisdiction. Combined, these scores are then used to determine an ‘anchor’ for a typical bank in that jurisdiction which, in turn, influences the stand-alone credit profile (SACP) for a bank (an assessment of its creditworthiness excluding the impact of extraordinary external influence). This SACP is then adjusted upwards or downwards in the light of likely government or parent company support, or possible contagion, to arrive at the rating.
“For example, for Irish banks, our economic risk score recently improved, reflecting our view of decreasing risks to the banking sector, arising from the correction of economic imbalances accumulated before the crisis,” Brennan explains.
Other major analytical changes introduced in the new bank-rating criteria, published in 2011, include a greater weight given to the capital resources available within a bank; profitability is assessed fundamentally with regard to its ability to generate capital. S&P’s own projected risk-adjusted capital ratio includes an assessment of the degree to which a bank’s capital and earnings would cover estimated losses following a period of substantial economic stress for developed countries.
“The criteria make earnings a component of the capital analysis, rather than a separate rating factor, measuring a bank’s capacity to absorb losses and build capital,” Brennan explains. “In theory, a bank’s product pricing includes a margin sufficient to cover the expected losses on its assets, which leaves capital to protect against unexpected losses.”
Would the new approach have made a difference during the crisis years? Brennan argues that the enhancements would lead to an adversely affected economic risk score in situations where there were issues of rapid growth, rapid changes in leverage and also sectoral concentrations in lending.
“All those were factors that were coming through in countries such as Ireland prior to the property crash,” she says.
It is clear that rating agencies have made changes to both the presentation and in the case of the financial sector, the substance of their methodologies for rating corporate credits. Quite how successful they have been will only be determined as we fight our way through the next credit crisis.