How should we rate the rating agencies? It is a question often asked by market participants and commentators. Some seem to think that you can evaluate ratings by looking at their impact on market prices. If a rating change is not accompanied by a change in bond spreads – or if bond prices diverge markedly from levels implied by ratings – some see it as a ‘failure’ by the ratings providers
That is the wrong test. Ratings and market indicators (bond spreads and credit default swap prices) cannot be directly compared because they are fundamentally different things. They are generated by very different processes and are often driven by different factors. Ratings provide a long-term subjective view of creditworthiness based on fundamental credit analysis, while market-based indicators reflect the ebb and flow of market sentiment, the liquidity of a security and many other short-term technical factors.
If the market reacts differently, or indifferently, to a rating action that does not say anything about the ‘quality’ of the rating action. Take eurozone sovereign ratings, for instance. For many years, before the recent debt crisis, the market valued debt issued by countries such as Greece and Italy roughly on a par with AAA-rated German government bonds, at a time when their credit ratings were significantly lower, and even after they were further downgraded from 2004/2005. It is a good example of how markets are volatile and prone to over or undershooting, while ratings remain relatively stable.
Ratings are valued by investors because they provide a consistent and comparable measure for assessing a very wide range of borrowers, and because they have a long track record.
Analysing such a broad universe of borrowers is often beyond the means of an individual investor so many choose to use external credit ratings, alongside other tools, to help in their decision process.
As the International Monetary Fund and other authorities have recognised, publicly available ratings improve the flow of information about credit risk and consequently the efficiency and liquidity of capital markets. They play an important role in helping debt issuers, including governments, financial institutions and companies, to access international pools of investment capital across the world. International investors use ratings because they want to compare the creditworthiness of borrowers on a like-for-like basis worldwide.
Credit ratings are forward-looking opinions about the relative creditworthiness of borrowers and the securities they issue. The higher the rating of an issuer or debt issue is, the lower the relative probability of default in the rating agency’s opinion.
To judge the performance of ratings, therefore, you have to look at their correlation over time with defaults, not with short-run movements in market prices. They should be assessed by comparing the default experience of a particular asset class and rating category against the long-term average for that asset class and rating category. That is a straightforward, and verifiable, empirical test.
Ratings agencies, regulators and many others publish extensive data looking at just this. Standard &Poor’s global fixed income research group, for example, publishes in-depth annual default studies covering a range of asset classes and regions.
The studies show that corporate and government ratings have continued to perform well as indicators of default risk during the financial crisis. They consistently demonstrate a close match between ratings and defaults across all regions and all periods. The higher the rating is, the lower the incidence of default, and vice versa. Higher ratings have proven progressively more stable than lower ratings.