Monday, October 10, 2011

Credit Ratings – Explained

In one of our previous articles, we learnt what Credit Ratings are.

It was just an introductory article about credit ratings. In this article we are going to learn what these credit ratings are and what they are not.

What are Credit Ratings?

Credit Ratings are:
a. An Expression/Opinion about Credit Risk
b. Are provided by Rating Agencies
c. Are Continually Evolving & Forward Looking
d. Are Intended to be Comparable across different sectors and regions

Credit Ratings are not:
a. An Investment Advise
b. Assurances of Credit Quality
c. Absolute measures of Default Probability

The points may look self-explanatory. Nonetheless, let us look in detail as to what each point means.

An Expression/Opinion about Credit Risk

Credit ratings express opinions about the ability and willingness of an issuer, such as a corporation or city government, to meet its financial obligations. Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation, and the relative likelihood that it may default.
Are provided by Rating Agencies

Credit Ratings are provided by Rating Agencies. There are many agencies whose sole purpose is to provide credit ratings about issues. Some of the famous ones are Standard & Poor’s, Moody’s, Fitch etc.

Are Forward Looking & Continually Evolving

Though credit ratings are arrived at based on the analysis and evaluation of historical data, rating opinions are designed to be forward looking. Simply put, ratings take into account not only the present situation but also the potential impact of future events on credit risk. For example, while assigning ratings, agencies factor in anticipated ups and downs of business cycles in specific industries as well as trends and events that can be reasonably anticipated.

At the same time, ratings are not static. Rating opinions may change if the credit quality of an issue or issuer alters in ways that were not expected at the time a rating was assigned. For example, the acquisition of a line of business, a change of policy by government, or erosion in the credit markets that was not foreseen may result in a rating adjustment that reflects this new information. The agency might choose to re-publish a revised credit rating for the affected party.

Are Intended To Be Comparable Across Different Sectors and Regions

Most rating agencies use the same rating scale across different types of companies. The rating scale is designed to provide a common language for comparing creditworthiness, regardless of the type of entity or assets underlying the debt instrument or the structure of the financial obligation.
This means that a ‘A’ rated party irrespective of whether it is a bank or a government or an automobile manufacturer carries the same level of credit risk as with other entities that have been assigned the same rating.

Are Not Investment Advise

Credit ratings are not designed to indicate the value, suitability, or merit of an investment. They are opinions of credit quality and, in some cases, the expected recovery in the event of default.

Credit ratings do not suggest whether:
• Investors should buy, sell, or hold rated securities
• A particular rated security is suitable for a particular investor or group of investors
• The expected return of a particular investment is adequate compensation for the risk it poses
• The price of a security is appropriate given its credit quality
• The market value of the security will remain stable over time

Though credit quality is an important consideration in evaluating an investment, it is not the sole criteria based on which you must base your investment decision.
Before deciding whether to invest in a particular investment option, the investor (you and me) must consider a wide range of factors like the investment strategy, time horizon, rate of returns, history of the house issuing the investment option etc. During this process the credit rating too will be considered but I repeat, we cannot and should not base our investment decision solely on the credit rating alone.

Are not Assurances of Credit Quality

Credit Ratings should not be viewed as an assurance of credit quality or the exact likelihood of default. Instead, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue.

Are Not Absolute Measures Of Default Probability

Credit ratings are not exact measures of the probability that a certain issuer or issue will default instead, they expressions of the relative credit risk of rated issuers and debt instruments.

Most rating agencies, rank order the issuers and issues from strongest to weakest based on their relative creditworthiness and credit quality.
For example, a AAA rated issue has a higher credit quality than a BBB issue.

Similarly, if we compare the historic data, the annual average default rate of BBB rated issues was 0.30%. this does not mean that it is a prediction that, any BBB rated issue has a 0.30% default probability. It may so happen that, this year the default rate could be 0.6% or even 0.2%. in fact, the actual default rates for any specific rating category may fluctuate over time and are governed by the economic factors.

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