Credit ratings – are they really the best indicators?
As the global debt crisis brings credit ratings into focus, questions surround their efficiency as an investment guide
The ongoing debt crisis in Europe has focused more attention than ever on credit ratings, but a key question that is often overlooked is whether credit ratings actually do the job they are designed for.
A credit rating is an opinion about relative credit-related risks – ranking the creditworthiness of an issuer or individual debt instrument, from strongest to weakest, within a universe of credit risk. It is not a guarantee of credit quality or an exact measure of the probability that a particular issuer or particular debt issue will default.
For example, a corporate bond rated AA is viewed as having a higher credit quality than a corporate bond with an A rating. The AA rating is not a guarantee that it will not default, but rather that it is less likely to default than the A-rated bond.
The performance of ratings can be measured objectively by how well they correlate over time with defaults, and by their stability, or the rate at which they change. Studies by Standard and Poor’s consistently demonstrate a clear correlation between ratings and defaults – the higher the issuer rating, the lower the observed frequency of default, and vice versa – and that ratings are progressively more stable as you ascend the ratings scale.
In the Standard & Poor’s long-term rating scale, issuers and debt issues that receive a rating of BBB- or above are generally considered by regulators and market participants to be investment grade, while those that receive a rating lower than BBB- are generally considered to be speculative grade, or ‘high yield’.
Between 1981 and 2011, the average five-year default rate for investment grade corporate issuers was 1.17 per cent, compared with 16.82 per cent for speculative grade companies. In Europe, over the same period, the average five-year default rate for investment grade corporate issuers has been 0.5 per cent, compared with 11.15 per cent for speculative grade companies.
Ratings continued to serve as effective indicators of relative credit risk over time, with a clear correlation between ratings and defaults. This was true for all rating categories and geographic regions.
In line with all previous default studies carried out by S&P, the 2011 study showed that entities with higher ratings default less frequently than those with lower ratings, higher ratings are more stable than lower ratings and speculative-grade ratings generally experience more volatility. This applied across all regions.
Moreover, the Gini ratio – a key measure of the relative ability of ratings to differentiate risk – was at its sixth-highest level since the default studies began in 1981. This demonstrates that the ability of corporate ratings to serve as an effective measure of relative risk remains intact.