CREDIT RATINGS - How to play the rating game.

One hundred years ago, US journalist John Moody had a novel idea. He decided to publish a manual of information and statistics on stocks and bonds of financial institutions, corporates and government agencies. The guide became an immediate best-seller, but Moody’s venture was wiped out in the 1907 stock market crash. Undaunted, he came back with a another idea: this time an analysis of security values for investors. Thus was born Moody’s Investors Service, the world’s largest rating agency, which now has more than 700 analysts working in 14 countries.

Today, Moody’s and the other rating agencies provide the criteria that enable investors to assess the credit worthiness of corporate and government securities, public finance obligations, sovereigns and other debt instruments. By doing so, they grease the wheels of commerce. “The rating agencies play a role in bond transactions in the sense that bond deals that are rated proceed more efficiently than ones that aren’t,” says Donna Halverstadt, executive director, fixed income, currency and commodities at Goldman Sachs. “In the US there are a number of investors whose internal guidelines require them to have ratings by Moody’s and/or Standard & Poor’s on the bonds they buy.” In this way, ratings become essential.

A different matter is whether investors and analysts view every rating as correct. They are often a good starting point because the rating agencies obtain much more information from companies than do sell-side analysts or investors. It is no secret that the agencies have good access to information and see things that are kept from analysts – but that doesn’t mean they’re always right. Moody’s itself acknowledges that a rating should be weighed solely as one factor in an investment decision and that an investor should make its own study and evaluation of any issuer whose securities or debt it is buying or selling.

It is also important to bear in mind that the rating agencies play a much different role to analysts or shareholders in relation to a corporate. Sell-side analysts are employed by stockbroking firms to make share recommendations to their client institutional investors – who will almost certainly have their own buy-side analysts. At least in theory, analysts have no vested interest in whether the recommendation is buy, sell or hold – though there isn’t much commission or dealing margin to be made out of a hold recommendation. That theory is tested further when a firm acts as corporate broker to a company (and hence is unlikely to rate the client as a sell) or by broad-based investment banks where the analysts are often brought in to advise corporate clients on M&A deals.

In contrast, the credit rating agencies are commissioned and paid by the corporates themselves to produce a rating. Typically, this happens when a corporate is issuing a bond or securitised asset. Though there is a commercial relationship between the business doing the rating and the business being rated, the agency’s reputation for accurate risk assessment is probably its most valuable asset and is squandered at its peril.

Moody’s and S&P’s dominate the US market, where ratings have for decades been vital tools for issuers and investors. But, with the advent of the euro bond market, European investors are becoming more rating conscious. “Now that European companies are issuing more corporate debt they’re probably more attuned to ratings and their implications,” says Halverstadt. “A company that traditionally just went to the bank to borrow money probably had little need to think about rating agency guidelines. Now you have a situation where companies borrow a lot of money in the debt capital markets and the rating is going to have a significant influence on pricing levels. Many companies will want to maintain a healthy enough rating so they can fund their business cost effectively.”

Barbara Ridpath, chief criteria officer for Europe at S&P’s, says the biggest growth area for the agencies is corporate bonds. “The banks want them to be liquid and sell them on to institutional investors,” she says.

However, as Halverstadt points out, the price makes the ultimate difference in the success of a bond transaction, not the rating. “In ‘normal’ market conditions, there’s a price for every bond,” she says. “However, there are times when people become concerned about credit quality, and ‘go on strike’ against credit product, making it difficult to bring tough credits to market.”

Ratings are basically tools for differentiating credit quality. Standard & Poor’s defines a rating as an opinion on the general creditworthiness of an obligor, or with respect to a particular debt security or other financial obligation. The rating process includes quantitative, qualitative and legal analysis. When S&P’s receives a rating request it assigns an analytical team and a lead analyst who drives the process and serves as the issuer’s primary contact. The lead analyst then prepares a report that is submitted to the rating committee. Once a rating has been assigned it is reviewed at least once every year.

Under S&P’s ratings system, companies in the AAA, AA, A and BBB categories are regarded as “investment grade”, or blue chip entities. Ratings in the BB, B, CCC, CC and C categories are those with significant speculative characteristics. Ratings are sometimes modified by the addition of a plus or minus sign to show their relative standing within the major categories. The system is further refined by “outlooks”, a notation that indicates the possible direction in which a rating may move over a two- or three-year period. Finally, CreditWatch listings highlight the potential for short-term change in a rating.

Moody’s long-term rating definitions range from Aaa to C, or from gilt edged bonds to those regarded as having extremely poor prospects of ever attaining any solid investment standing. On this scale, any bonds below Ba generally lack characteristics of a desirable investment. These ratings may also be modified: 1 indicates the higher end of the rating category; 2 indicates a mid-range ranking; 3 indicates a ranking in the lower end.

Moody’s short-term debt ratings are opinions of the ability of issuers to repay senior debt obligations punctually. They range from Prime-1 to Prime-3 and they can be defined as superior repayment ability through strong and down to acceptable ability. Anything below that is rated Not Prime.

Fitch uses long-term international AAA to BBB categories or short-term F1 to F3 to define investment grade ratings. Those in the speculative or non-investment grade categories are rated international long-term BB to D or short-term B to D. Variable rate demand obligations and other securities that contain a demand feature will have a dual rating, such as AAA/F1+. The first rating denotes long-term ability to make payments. The second denotes ability to meet a demand on time.

Paul Taylor, group managing director at Fitch says that a ratings assessment involves checks on the issuer and the guarantor, if there is one. “When assessing ratings, we consider the historical and prospective financial condition, the quality of management and operating performance of both the issuer and of any guarantor,” he says.

While more than a hundred agencies are active in assigning ratings to companies, government borrowers and financial institutions, only the two US agencies Moody’s and Standard & Poor’s, and London-based Fitch, can claim to operate on a global scale and exercise a significant influence on the market.

Until last year, there was a middle tier of agencies. IBCA and Thomson Bankwatch covered banks, Fitch looked at US structured finance and Duff & Phelps was a mix of the two. However, these were all pulled together through mergers to create the new Fitch, leaving a huge gap between the small players and what are now the big three.

“Until last year we were overshadowed by the big US agencies,” says Taylor. “There is a perception that our merger process has reduced competition, but in fact the reverse is true when you consider that in the past there were a number of small agencies buzzing around the edges of the big business.”

The big three can strike terror in the hearts of people seeking to raise capital in the debt markets, for a rating is largely what determines the borrower’s ability to issue on favourable terms. Last year, a number of telecom companies were downgraded, making it more expensive for them to access the capital markets, when investors began to fear they had set over ambitious profit targets.

Take the example of Dutch telecom Royal KPN, which recently became the first European incumbent to cross the BBB barrier when S&P’s moved from a negative outlook to a downgrade on the company, lowering its long-term rating to BBB+ from A-. KPN’s debt had widened since last December in anticipation of a downgrade and when it happened the company’s 2005 euro paper increased by 10 basis points to trade at Euribor plus 158. The bonds affected amount to more than EUR6bn.

“The impact on the success of an issue can be particularly dramatic in Europe, as the credit culture is new and people have only recently become interested in credit as opposed to foreign exchange,” says Ridpath. “Last summer’s telecom problems are just one example of how the agencies affect issues.”

Small wonder then that banks, which are in the game of raising capital at the cheapest possible cost, have a particular interest in convincing the agencies of their capital management skills. “It’s apparent that the banks strive to keep their capital ratios up more for the rating agencies than for the regulators,” says an analyst at a US investment bank.

The rating agencies are currently very much in the spotlight vis-a-vis the banks with the recent unveiling of the new Basle regulatory accord. This will replace the 1988 directive that aimed to increase the capital held by banks following the Latin American debt crisis of the early 1980s. In its simplest version, the new accord enhances the rating agencies’ role by requiring most banks to use external sources (ie, the agencies) to assess the amount of capital they need to set aside to cover borrower risk. The larger and more sophisticated banks will be allowed to use their own internal risk models, but, as Taylor points out, most banks use the agencies’ input to build these internal systems.

The agencies have so far come out in support of the revised Basle accord, in spite of criticism from some quarters that it would appear to cast them in the role of regulators. “We don’t want to be regulators as we are free market entrepreneurs,” says Taylor.

Moody’s view is that it agrees with the Basle Committee’s position that an internal ratings-based regime can provide a more accurate assessment of risk for sophisticated banks than the current capital adequacy framework. But Taylor believes that in some respects, Basle II is a non-event. “The rating agencies are growing in spite of regulatory changes,” he says. “There is a big demand for the product from investors and Basle is merely an add-on to that process.”

RATINGS DEFINED

MOODY’S LONG-TERM DEBT RATINGS

Aaa: Best quality. Smallest degree of risk. “Gilt edged”. Interest payments protected by a large or very stable margin and principal is secure.

Aa: Of high quality by all standards. Margins of protection may not be as large as Aaa or fluctuation of protective elements may be of greater amplitude.

A: Many favourable attributes; upper-medium-grade obligations. Security considered adequate, but may be susceptible to impairment in the future.

Baa: Medium-grade obligations, neither highly protected nor poorly secured. Security appears adequate at present but certain protective elements may be unreliable over any great length of time. Speculative characteristics.

Ba: Judged to have speculative elements; future cannot be considered as well-assured. The protection of interest and principal payments may be very moderate and not well safeguarded during both good and bad times.

B: General lacks characteristics of a desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small.

Caa: Of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest.

Ca: Speculative in a high degree. Such issues are often in default or have other marked shortcomings.

C: Extremely poor prospects of ever attaining any real investment standing.

STANDARD & POOR’S LONG-TERM ISSUER CREDIT RATINGS

AAA: Extremely strong capacity to meet its financial commitments. The highest Issuer Credit Rating assigned by Standard & Poor’s.

AA: Very strong capacity to meet its financial commitments. It differs from the highest rated obligors only in small degree.

A: Strong capacity to meet its financial commitments but is somewhat more susceptible to changes in circumstances.

BBB: Adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to meet its financial commitments.

BB: BB, B, CCC, and CC rating have significant speculative characteristics. BB is less vulnerable near term but faces major uncertainties; adverse conditions could lead to inadequate capacity to meet commitments.

B: More vulnerable than obligors rated BB, but currently has the capacity to meet financial commitments. Adverse conditions will likely impair the obligor’s capacity or willingness to meet its financial commitments.

CCC: Currently vulnerable and is dependent upon favourable business, financial, and economic conditions to meet financial commitments.

CC: Currently highly vulnerable.

SOURCES: Moody’s; Standard & Poor’s; edited and compiled by Financial Director.