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.
Globally none of the 66 rated companies and financial institutions that defaulted in 2012 had S&P investment grade ratings (BBB- and above) at the start of the year, and around 80 per cent of them were rated B- or lower at the beginning of 2012. Ninety per cent of corporates globally that defaulted last year, including all nine European defaulters, had initial (first) ratings that were sub-investment grade (BB+ and below). Of the 10 per cent that were originally rated investment grade, the average time to default – the time between first rating and date of default – was 17.6 years.
Since 1981 only 1.1 per cent of companies globally that were rated investment grade have defaulted within five years, compared with 16.4 per cent of companies that were rated sub-investment grade. Ratings continue to remain relatively stable. Seventy-two per cent of corporate ratings globally were unchanged in 2012, similar to the annual average of the past 10 years.
Likewise sovereign ratings have an excellent long-term track record. An IMF study in October 2010 found that credit ratings agencies provide a robust ranking of sovereign default risk, meaning defaults tend to cluster in the lowest rating grades. Since 1975 an average of 1 per cent of investment-grade sovereigns rated by S&P have defaulted on their foreign currency debt within 15 years, compared with around 30 per cent of those in the non-investment grade category. All sovereigns that have defaulted in the past 40 years, including Greece, Grenada and Belize, which defaulted in 2012, had sub-investment grade ratings at least a year before default.
S&P data shows that the relative rank ordering of sovereign ratings has been consistent with historical default experience. Sovereign ratings have been no more volatile than ratings on companies and financial institutions. In 2012 S&P downgraded 17 per cent of rated sovereigns and upgraded 8 per cent, while 75 per cent were unchanged. Sovereign ratings have also exhibited greater stability at higher rating levels than at lower levels.
As has been said many times before, S&P was disappointed by the performance of its ratings on certain US mortgage-backed securities and regrets that, like many others, it did not foresee the speed and severity of the US housing downturn.
In other areas of structured finance, including mortgage markets outside the US, its ratings have generally held up well in the crisis and have continued to perform strongly. This includes European structured finance where default rates have been low, despite the severity of the recession and property market stresses in Europe. Only 1.4 per cent (by original issuance value) of rated European securitisations outstanding at mid-2007 had defaulted by the end of 2012, and S&P ratings on about two-thirds of these instruments have either been stable or have risen in this period.
There is no mystery about ratings performance. It can be found in the data published by ratings agencies and others and which S&P, for instance, makes freely available to market participants and the wider public. It also appears in the ‘ratings comparison’ website maintained by the European Securities and Markets Authority that shows the comparative performance of 18 registered or certified ratings agencies in the European Union.
When judged with hindsight, ratings do not always correlate with how events unfolded. They are subjective opinions about the future which can be affected by unpredictable events and factors. They are not guarantees about default risk. Investors sometimes disagree, as reflected in market prices, yet the evidence shows that ratings in general continue to be closely correlated with defaults. And that is the real test for rating the raters.
Yann Le Pallec is executive managing director of Standard & Poor’s ratings services in EMEA
Key points
Ratings and market indicators (bond spreads and credit default swap prices) cannot be directly compared because they are fundamentally different things.
Credit ratings are forward-looking opinions about the relative creditworthiness of borrowers and the securities they issue.
Sovereign ratings also have an excellent long-term track record.
