Despite the attention and column inches devoted to credit ratings agencies (CRAs) in recent years, misunderstandings about their purpose and methods continue to circulate. In particular, there remains a belief in some sections of the investment community that ratings are intended to be investment recommendations, while other market participants have suggested in recent times that rating agencies are subject to conflicts of interest.
In our own case, Standard & Poor’s Ratings Services (S&P) has focused significant efforts on improving understanding about our ratings. The aim is to help both investors and issuers – including corporate treasurers – understand what ratings are and how to use them appropriately. The aim is for the firm to be judged on its track record of issuing credit ratings as opinions of default risk; that is the long term link between ratings and default.
Ratings as Investment Recommendations
Credit ratings are not buy or sell recommendations, nor are they substitutes for independent investment analysis. Instead, ratings are an opinion about the ability of the debt issuer to service its financial obligations.
For example, an issuer with a high credit rating is assessed by S&P to have a lower likelihood of default than an issuer with a lower credit rating. However this does not make a top rating a guarantee against default. Even an issuer or security originally rated ‘AAA’ might, over time, default – although experience shows that default rates for AAA-rated debt are generally lower than for other rated debt.
What’s more, ratings are not short term investment indicators and should not drive investment decisions. However, many investors do value ratings as an independent and comparable benchmark of credit risk and choose to use them, alongside other inputs, in their fixed income portfolio process.
Certainly, the stability of ratings contributes to their usefulness. While ratings can and do change during credit cycles, the changes are generally incremental. Even so, sharp market movements are often blamed on ratings changes, despite the numerous other factors driving investor behaviour such as market price, liquidity and investment strategy.
In reality, markets often anticipate rating adjustments well in advance, given that the outlooks (negative, stable, positive) attached to ratings give an indication of their likely future direction. Studies by the International Monetary Fund (IMF) and others suggest that markets respond more to changes in rating outlooks than to actual downgrades or upgrades.
What’s more, investment managers typically have the flexibility to respond discerningly and in good time to rating changes. There is little evidence of forced selling when ratings fall below ‘investment grade’ or AAA, for instance.
The Behaviour of Ratings Agencies
Ratings agencies are also criticised for being unaccountable when they are, in fact, intensely scrutinised by the market and media thanks to the wide dissemination of their research and opinions. Moreover, ratings agencies are supervised by regulators around the world, including the European Securities and Markets Authority (ESMA) in the EU. Changes to regulation in recent years have strengthened market confidence in ratings by increasing their oversight, transparency and accountability.
Additionally, S&P often updates its criteria to support the transparency and comparability of its ratings. For example, in November 2013, after extensive market consultation, it updated its criteria for rating industrial companies and utilities. The new criteria provide much greater insight into the ratings process and enhance the global comparability of corporate ratings through the use of a comprehensive, clear and globally consistent framework.
Also under regular review is the ‘issuer-pays’ business model of ratings agencies. In this respect, the key consideration is how potential conflicts of interest are managed internally and overseen by regulators, and what system works best for investors. As such, established policies and procedures have long been in place to support the integrity of ratings, including the separation of analytical and commercial activities.
Major ratings agencies use the issuer-pays model because it enables the public to access ratings free of charge, thus maximising public scrutiny. An investor-pays model, on the other hand, would favour subscribers and deny information to ordinary investors, which would work against a truly fair, transparent market.
Finally, ratings agencies are often accused of not having learned from the financial crisis. In truth, like many in the financial sector, S&P has taken to heart the events of the last five years, spending approximately US$400m to reinforce the integrity, independence and performance of its ratings. Methodologies and monitoring of global credit risks have been improved, new leadership has been brought in, and higher requirements for achieving AAA ratings have been set. We believe that the improvements make ratings more comparable, forward looking and easier to understand.
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