Credit ratings ans assignmment

715 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
715
On SlideShare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
20
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Credit ratings ans assignmment

  1. 1. Credit Ratingsby David WyssExecutive 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.IntroductionThere 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 FimalacSA). In addition, there are many regional and niche rating agencies that tend to specialize in a geographicalregion or industry. The major agencies state that their opinions of the credit quality of securities are basedon established, consistently applied, and transparent ratings criteria. Although the agencies use differentcriteria, definitions, and rating scales, they each state a view on the probability that an entity or security willdefault. Some rating agencies also assess the potential for recovery—how likely the investors are to recouptheir investment in the event of default.Issuers of most fixed-income securities issued in world financial markets request and receive a credit ratingfrom a rating agency. Although credit rating evaluations are not always required, they may increase themarketability of a debt instrument by providing investors with an independent opinion about the instrument’srelative 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 tosee an established opinion about the credit quality of a security that is not from the issuer or underwriter. Inaddition, some funds have made it a requirement for their investment guidelines or as part of what they havepromised their investors. Issuers who are not well known or who are trying to sell into international marketsmay 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 andtransition studies. Over the long run, securities with a higher credit rating have consistently had lower defaultrates than securities with lower ratings. Ratings are just opinions, however, and there have been certainperiods when highly rated securities in a specific sector ultimately performed worse than other securitiesrated in the same category. Accordingly, ratings do not remove the need for the investor to understand whathe 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 therating opinion. Investors are encouraged to read the detailed analysis carefully to understand why an agencyassigned a particular rating.Having a rating may be useful even if a corporation elects to raise money privately rather than through apublic bond issue. Obtaining a rating may make it easier for a company to seek funding from a private lenderor bank. Although not every company needs a credit rating, most medium-sized or larger firms find it useful.Credit Ratings 1 of 5 www.qfinance.com
  2. 2. How a Rating Is AssignedCredit 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 inaccordance with their terms. The agency’s analysts consider a broad range of business and financial risksthat may interfere with prompt and full payment.Most rating agencies use a mix of quantitative and qualitative analysis. Typically, analysts who considerqualitative factors contact management at the firm being rated to obtain additional information that may helpthem to arrive at an informed opinion. In some cases, they will ask for information that is not available to thegeneral public, such as details of business plans, strategies, and forecasts. Agencies generally also examinethe 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 ratingbased on its overall financial strength. An individual issue is usually given an evaluation based on informationprovided 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 financialstatements. In most cases, the rating agency will also meet with the issuer to discuss any questions thatthe 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 mayinclude rating all new debt issues.Credit ratings from the major rating agencies are normally paid for by the issuer of the securities, and aremade 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 accessto the issuer for questioning, they are usually marked as “public information” or given similar subscripting bythe rating agency. The issuer-pays model has two hallmarks: First, the major rating agencies make ratingspublic (and if they didn’t, that news would quickly become public), so it is hard to get investors to pay forwhat they can get for free on the news. Second, issuing a rating often involves access to the company’sconfidential data, which is not permissible under a subscriber-pays model.In some circumstances, most agencies will rate some securities without any consultation with the issuingfirm. 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 beissued for an individual investor or group of investors, usually for a security that is not intended for publictrading. Many firms want a confidential rating for management purposes and as a second opinion on thecredit quality of a loan.Ratings are not static, and rating opinions can change (or transition) if the credit quality changes in waysthat were not expected at the time the security was issued. Ratings may be reviewed and updated on aregular basis, or when a significant change occurs in the performance of the issuer, the markets, or theeconomy. The acquisition or divestiture of a company, a political threat to (or from) the government, orerosion in the economy or credit markets can cause a rating to be adjusted. Normally, warning of a likelychange is provided through an “outlook” or “credit watch” that states the direction in which a rating maymove. However, sometimes a sudden deterioration may force a shift in a rating with little warning.Rating ScaleEach credit rating agency uses its own criteria and methodology to evaluate creditworthiness. The processmay be predominantly quantitative or qualitative, but is usually a blend of the two. Once an agencycompletes the analysis, it issues a rating based on its own scale. Ratings are typically expressed as agrade, such as AAA, BB, or CC, with AAA (or equivalent) denoting the strongest and D (or its equivalent) theCredit Ratings 2 of 5 www.qfinance.com
  3. 3. weakest (i.e. that a default has already occurred). Note that the rating scale for short-term instruments suchas commercial paper is different from the long-term scale. For example, at S&P the top long-term rating isAAA, while the highest short-term credit rating is A-1+. D stands for default in both scales.Although a rating scale is relatively straightforward, the assumptions, considerations, and judgments behindthe opinions can be complex. Most agencies explain their rationale in published documents that may be readby investors. Among others, the risk factors include the financial performance of the firm, the characteristicsof the economy and industry it operates, and the quality of its management. Standard & Poor’s credit ratingsstrive to be forward-looking, focusing not just on the past but also on the likely future state of the industry andthe firm.Standard & Poor’s ratings are intended to be consistent across all issuers and debt instruments. Over thevery long term, all instruments with the same (say, A) rating are expected to have similar default experience.However, the short-term behavior of these instruments may be very different. Different industries responddifferently to economic and credit cycles.Credit ratings are not exact measures of the default probability of an issue or issuer, but an opinion aboutrelative credit risk. In assigning ratings, agencies rank relative credit risk from strongest to weakest, based onrelative creditworthiness and credit quality within the rated universe. Actual default probabilities may changeover time.RecoverySome credit rating agencies incorporate the potential for recovery into their opinions, while others may givea recovery rating that is separate from the credit rating. Recovery prospects after default are an importantcomponent in evaluating credit quality, particularly in evaluating more risky debt issues.Islamic CreditMounting demand for shariah-compliant financial products and services has fueled the rapid expansion ofthe Islamic banking industry. More and more banking clients are choosing to invest in a broadening range ofIslamic financial instruments (IFI) through long-established banks in the Gulf Cooperation Council (GCC) andMalaysia. The model has spread beyond the Gulf to the Maghreb and Muslim Asia, as well as to Muslims inpredominantly non-Muslim countries in the West, Asia, and Africa.Demand for shariah-compliant instruments has risen sharply as a result of strong economic growth withinthe Islamic world and the large surpluses of the oil-producing countries. The volume of shariah-compliantinstruments outstanding is estimated at over $500 billion, with sukuk (an Islamic financial certificate)issuance reaching $100 billion. Islamic banks have focused on the retail segment in the Arab world andMalaysia but are expanding to other countries. North Africa has been a recent region of strong growth,with Tunisia and Morocco authorizing Islamic banks for the first time in 2007. The central bank of Moroccobecame a shareholder in the International Financial Services Board (based in Malaysia), which serves as atransnational regulatory body to harmonize regulation and supervision for Islamic banks.Islamic securities such as sukuk are rated by agencies employing the same fundamental analysis as areused for rating other issues. The rating provided does not, however, express an opinion regarding theshariah compliance of any Islamic financing instrument, institution, or debt issue. It is the responsibility ofthe shariah board of the originating institution to rule on compliance with Islamic law. The agency rates thesecurity based on its analysis of the willingness and ability of the issuer to make the agreed payments, asspecified in the security.Ratings and InvestmentAlthough credit quality is an important element in an investment decision, it is not the only or even the mostimportant element. Ratings opinions are not investment recommendations. In making any investment, theinvestor should consider the trade-off between risk and reward. Credit quality is only a partial measure of oneof those trade-offs.Credit Ratings 3 of 5 www.qfinance.com
  4. 4. A security’s price is generally one of the most important considerations for an investor. If the price is lowenough, almost any investment becomes desirable; if the price is too high, any investment becomesunattractive. The price determines the long-run return on the investment, assuming that it pays as scheduled.As a minimum, three other factors besides price and credit quality should be considered. First, what is thedownside risk or likely recovery if the security defaults? Second, what is the liquidity of the investment—howeasy is it to sell if it must be disposed of before its maturity date, and how responsive is pricing to changes ininterest rates or the market environment?An important issue for investors buying outside their home country is the potential for exchange rate changeor government interference with the ability to collect payment. Fortunately, foreign exchange controls havebecome very rare outside of a few very weak emerging economies, but foreign exchange risk is very real.The US dollar/euro exchange rate went up 20% in early 2008 and then down 20% over the next threemonths.ConclusionCredit ratings may be used by investors and other market participants in making investment and businessdecisions that are aligned with their risk tolerance or credit risk guidelines. Credit ratings are opinions aboutthe perceived credit risk of a particular debt issue. In general, the greater the credit risk, the higher the returninvestors may expect for assuming that risk. For that reason, credit ratings may be useful for both issuersand investors when a debt issue is first issued in the primary markets and continues to be so for investorswho trade securities in secondary markets.Making It Happen • Ratings can be obtained from a variety of agencies. Consider who will be your likely investors before deciding to go with a global or a local rating agency. • Have your financial and business plans in order and fully audited by a reputable firm before trying to get a rating. • Ratings are opinions about credit risk, and not investment advice or opinions on pricing. • Work with your banker on determining which agency to use and whether a rating is desirable.More InfoBooks: • 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.Article: • Cantor, Richard. “An introduction to recent research on credit ratings.” Journal of Banking and Finance 28:11 (November 2004): 2565–2573. Online at: dx.doi.org/10.1016/j.jbankfin.2004.06.002Websites: • The main sources of information on ratings are the websites of the three major rating agencies: www.moodys.com, www.standardandpoors.com, and www.fitchratings.com. A good discussion of ratings trends is found in the “Guide to credit rating essentials” produced by Standard & Poor’s (2008, 20 pages): tinyurl.com/3942qmn [PDF].Credit Ratings 4 of 5 www.qfinance.com
  5. 5. See AlsoBest Practice • Investing in Structured Finance Products in the Debt Money Markets • Minimizing Credit RiskChecklists • The Bond Market: Its Structure and Function • How to Manage Your Credit Rating • How to Use Credit Rating AgenciesTo see this article on-line, please visithttp://www.qfinance.com/financing-best-practice/credit-ratings?fullCredit Ratings 5 of 5 www.qfinance.com

×