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The role of credit ratings

A credit rating agency is an independent company that evaluates risk, credit worthiness and credit quality and assigns a rating to an issuer of debt obligations as well as the debt instruments they issue.

The credit rating is a forward-looking opinion about credit risk and the ability and willingness of an issuer to meet its financial obligations in full and on time.  The likelihood of default is an important factor in the agency’s evaluation. National governments, corporations, local governments, non-profit organisations and special purpose entities are typically rated. The rating is very important to the issuer as it will affect the interest rate that the issuer will need to pay investors. The stronger the credit rating, the lower the rate and interest expense for the issuer. The largest credit agencies are Standard and Poor’s, Moody’s, Fitch Ratings and Dun & Bradstreet.

The agencies generally provide a short and long term rating. The rating scales slightly differ by agency, and typically have letter designations. The highest quality long-term credit rating by Standard and Poor’s and Fitch is AAA. This rating means a borrower has extremely strong capacity to meet its financial commitments. The ratings then go down by notches. The next level lower from AAA is AA+. This means the borrower has very strong capacity to meet its financial commitments and there is only a small degree of difference from the highest rating. This holds the same as the notches decline to AA, AA-, until A+.  At this level, and at A and A- the borrower is believed to have strong capacity to meet its financial commitments but is somewhat susceptible to adverse effects in changes in circumstances and economic conditions.

A borrower is considered to have adequate capacity to meet its financial commitments from BBB+ to BBB-. Ratings up to this point are considered investment grade, a relatively low level of risk of default.  rom BB+ downward, the credit rating is considered to be non-investment grade, also called high yielding or junk, and is considered to be high risk and speculative. At CCC-, the issue would be in default with little prospect of recovery.

Rating agencies have been criticised as key enablers of the financial meltdown. Until the early 1970s, credit agencies were paid by investors seeking unbiased information on the credit worthiness of bond issuers. That changed when bond issuers started paying agencies to rate their issues, which critics claim is a conflict of interest. Bond issuers have been accused of shopping among the credit agencies for the most favourable rating.

The agencies were also lambasted for underestimating the risks involved with new and complex securities such as mortgage-backed securities and collateralised debt obligations. The investment grade ratings given to these securities encouraged a heavy flow of funds which helped fund the housing bubble. Their downgrades in 2007 and 2008 caused chaos in the markets. Given past concerns, some are now criticising the agencies of being overly zealous.  Standard and Poor’s unprecedented downgrade of the US to AA+, although generally anticipated, has resulted in some extremely negative reactions and havoc in the markets.

Thus is it safe to say, a rating agency’s decision can have considerable influence, and as we are presently learning, impact the market’s direction.

Anthony Galliano is the chief executive of Cambodian Investment Management.
anthonygalliano@covenantim.com

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