Busting sovereign rating myths
With action taken on the credit ratings of nine eurozone countries at the start of the year, and the downgrade of the US last August, sovereign ratings have made headline news.
However, their elevated profile has also revealed certain myths among investors and advisers as to their role, reliability and use.
Credit ratings are assessments of creditworthiness, not assessments of investment merit
The most common misunderstanding about credit ratings is also probably the most basic. Independent reviews, such as the FSA’s Turner Report, have shown that even specialist investors have sometimes become confused about what a credit rating is.
A Standard & Poor’s (S&P) credit rating is a forward-looking opinion about the creditworthiness of a company or institution, in this case sovereign borrowers. The rating is not an assessment of the merits of issuers’ debt as an investment. Beyond creditworthiness, the rating does not offer information on factors that are essential to making decisions about investments. This is apparent in the different prices allotted to debt instruments that possess the same credit rating.
Instead, the rating reflects a view on both the capacity and, importantly, the willingness of the borrower to meet its financial commitments in full. The latter concern was at the heart of the one notch downgrade of the US in August last year, in response to the prolonged, contentious and fitful nature of the government’s debate on fiscal policy.
While credit quality may be a factor in investment decisions, there are numerous other factors investors may consider prior to deciding whether to buy, sell or hold. These include not only market price and liquidity, but the investor’s particular investment strategy, their tolerance for risk, the make-up of their portfolios and their assessment of a potential investment’s value in comparison with other opportunities. None of these factors are addressed by credit ratings.
Credit ratings are opinions on a borrower’s relative creditworthiness, not an absolute measure of the probability they will default
Ratings convey opinions about the relative, not absolute, creditworthiness of a borrower, or the credit quality of an individual debt instrument. That is because credit ratings are not an exact science – there are always going to be events and developments that are unexpected. Consequently, credit ratings are intended to express a credit rating agency’s perspective on relative credit quality, from strongest to weakest, within a complete set of credit risks. At S&P, these ratings range from AAA – the company’s capacity to meet its financial commitment on the obligation is extremely strong – to C, obligations that are currently highly vulnerable to non-payment, with ‘D’ ratings handed out when borrowers default on their obligations.