What credit ratings offer
It is increasingly accepted that defined benefit (DB) pension scheme deficits are ‘debt like’ in nature and that the financial strength of the sponsor is one of the key factors that determines the security of the scheme itself. A key measure of a sponsor’s financial strength is its credit rating. This article looks at the default probability associated with credit ratings from a trustee’s perspective and the extent to which credit ratings can change over time.
So why is the credit rating default experience important to trustees? Standard & Poor’s (S&P) has continuous default records since 1981. Over this period, the number of companies that have ratings has increased significantly, and this provides increased confidence in the historic performance of ratings as an indicator of future default.
Table 1 shows that an entity rated BBB has an historic probability of default of 6.7% over a 10-year period. It can be seen that the 10-year default experience increases significantly as credit quality weakens to the CCC/C level, ie, the probability of such entities meeting its obligations over a 10-year period is 42.03% (100% less 57.97%).
It would seem prudent therefore that trustees use such estimates of the likelihood of sponsor continuity in determining the contribution and investment strategies for a scheme.
Credit rating movements over time are not a static measure; they both strengthen and weaken. The long-term nature of pension liabilities, which often stretch over decades, makes the movements of a sponsor’s credit strength particularly significant to trustees where there is long-term dependency on the sponsor, for example, in the funding of a deficit.
The tables show S&P’s historical experience of how ratings migrate over five- and 10-year periods. Looking at AA ratings over a five-year period, on average only half of entities (54%) have maintained AA credit strength; 2% have strengthened to AAA, nearly one in four (22.7%) have weakened to A, and a small number (0.3 %) have defaulted to ‘D’ ”. In this context, 16.4% have become non-rated. (Non-rated cases are entities or debt issues that have ceased to be rated.) There can be many reasons for a de-rating but, as far as possible, S&P checks that there is no public record of a default. If non-rated companies have subsequently defaulted, the result will be shown in column D.
For a trustee, movement of a sponsor from a rated state to a non-rated state is of great significance. There are many benign explanations for de-rating, such as repayment of the rated debt, takeover etc, but any potential change in the sponsor’s credit strength is a significant development. Generally, trustees should attempt to re-establish some form of credit assessment of the sponsor given that the sponsor’s credit strength is a major component of much of the trustees’ decision-making.
The 10-year data of ratings migration (see table 3), which is not a long period relative to the duration of pension liabilities, shows a higher level of relative change. Broadly, over this period, no more than a third of credit ratings have remained the same. Equally, non-rated cases have increased quite significantly indicating the dynamic nature of corporate activity occurring in many sectors.
This data highlights the significant differences in timescales between sponsors and schemes. Over a 10-year period, there can be significant change in the circumstances and financial strength of a sponsor. In pension scheme terms, 10 years is unlikely to cause a great deal of change – particularly if the scheme is open and new members are roughly equal in number to pensioners dying. Even with closed schemes, the relative changes may be quite modest – after 10 years, scheme members are probably fewer in number but with a higher proportion now drawing pensions for up to a further 10 or 20 years. It can be observed from table 3 the general stability of credit strength over a longer period.
Table 4 summarises from one to 20 years the average historical probability of ratings remaining the same for each grade. The data illustrates the extent to which credit strength is a dynamic quality over periods of time, which cannot be considered as being long relative to the nature of the underlying pension liabilities.
Trustees need to be aware of these patterns of stability and development as an active constituent of their decision-making strategies, covering their statements of both funding objectives and investment principles. It is almost unavoidable that an appropriate strategy today can relatively rapidly be significantly altered by movements in the sponsor’s credit strength.
Having reviewed historic measures of ratings stability, there is little doubt that this level of change is likely to continue in the future. Low economic growth of itself may create greater levels of competition and consolidation, increasing credit strength dynamics to an even higher level.
In anticipating changes in credit strength, S&P’s credit ratings are usually accompanied by an outlook statement indicating whether the rating is likely to change in the future. A positive outlook indicates that the credit rating is more likely to strengthen than weaken in the future, while a negative outlook suggests the opposite. The absence of an outlook indicates that the rating is judged unlikely to change in the prospective future.
Outlooks are determined based on the internal dynamics of the entity being rated. S&P also issues credit-watch statements, which are usually driven by external factors such as a takeover or changes in key legislation. Again these take the form of positive, negative or developing outlook. A developing creditwatch indicates that a change is likely without suggesting the direction of change. Generally, creditwatch statements should be resolved relatively quickly, ie, when the externally driven event is resolved.
The significance for trustees of these indications of possible future change in the sponsor’s rating can be considerable, particularly where there is the prospect of a sponsor crossing the BBB/BB boundary (ie, moving from investment to speculative grade). As shown in table 1, the chance of default of a BB sponsor within five years (12.1%) is four times higher than that of a BBB over the same period. Over a 10-year period, the default probabilities are similarly disparate, BBB 6.7% relative to BB 20.53%.
Trustees have the challenging task of managing fund assets and liabilities over extended periods of time. The strength of the sponsor is a key component of their risk-based decisio-making, particularly where there is long-term dependency of the scheme on the sponsor. Credit ratings are a good indicator of sponsor financial strength but must be kept under review constantly. As greater emphasis is placed on the scheme-specific duties of trustees and if the pace of commercial change continues at its current rate, trustees must be sure to pay increased attention to their sponsor’s financial strength.
Jim MacLachlan is director of pensions at Standard Poor’s