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Credit Ratings: Myth vs Reality Credit ratings agencies have received a lot of attention in recent years, yet confusion remains about their role and how they operate. We look at 10 common myths about the industry.

Credit Ratings: Myth vs Reality

by Yann le Pallec, Executive Managing Director, EMEA Ratings Services, Standard & Poor’s

Credit ratings agencies have received a lot of attention in recent years, yet confusion remains about their role and how they operate. In this article the EMEA head of Standard & Poor’s Ratings Services addresses 10 common myths about the industry.

Myth 1

A credit rating tells me whether or not I have a good investment

Credit ratings are not buy or sell recommendations, nor are they substitutes for independent investment analysis. Instead, ratings are an opinion about the capacity and willingness of a borrower to meet its financial obligations in full and on time.

Creditworthiness can be an important consideration in a decision on whether or not to invest. However, there are numerous other factors that investors should consider, including market price, liquidity and investment strategy. Early in the financial crisis, for example, the market price of many European securitised bonds fell sharply despite the relatively low level of defaults they subsequently experienced.

Myth 2

A high credit rating, such as ‘AAA’, is a guarantee against default

An ‘AAA’ credit rating means that, in S&P’s view, the debt issuer has a stronger capacity to meet its financial commitments than other more lowly rated borrowers. It is not, however, a guarantee against default. Even an issuer or security originally rated AAA might, over time, default – though experience shows that default rates for AAA-rated debt are generally lower than for other rated debt.

Myth 3

Ratings are poor indicators of default risk

The majority of credit ratings have performed well historically, as measured by their correlation over time with defaults.

Certainly, the performance of many US mortgage-related securities issued before the crisis has been very disappointing; we regret that, like others, we did not anticipate the scale of the problems that subsequently emerged in the US housing market.

Elsewhere, however, ratings have maintained their strong track record. Since 1981, only 1.1% of companies globally that were rated investment grade have defaulted within five years, compared with 16.4% of companies that were rated sub-investment grade. Likewise, every sovereign borrower that defaulted in the last 40 years had sub-investment grade ratings at least a year before default.

Ratings agencies, regulators and many others publish extensive data on the track record of ratings. These studies consistently show that default rates rise with each step down the ratings scale and that higher ratings are more stable than lower ratings.

Myth 4

Credit ratings are ignored by markets

From time to time, market prices can and do diverge from ratings, as markets are driven by many factors beyond ratings. For example, for several years before the recent Eurozone debt crisis, markets valued bonds of countries such as Greece and Italy broadly on a par with AAA-rated German government bonds, while their ratings were considerably lower (and were downgraded further from 2004/5). Since then, Eurozone sovereign bonds spreads have come back more into line with ratings.

Markets may react variably to rating changes, depending on investor sentiment at the time. In fact, markets often anticipate rating changes well in advance, given the signals that ratings agencies give about the future direction of ratings. Studies by the IMF and others suggest that markets respond more to changes in rating Outlooks or other indicators, rather than to actual downgrades or upgrades.

Ratings are not short-term investment indicators and should not drive investment decisions. But many investors do value ratings as an independent and comparable benchmark of credit risk, and choose to use ratings as one of many inputs in their investment process or to screen potential investments.

Myth 5

Ratings destabilise markets

Ratings are sometimes blamed for causing sharp market movements, despite the many other factors driving investor behaviour (including investors’ own analysis of credit risk).

The reality is that ratings are much more stable than market prices. While ratings can and often do change during any credit cycle, the changes are generally incremental.

At the same time, investment managers typically have flexibility to respond discerningly and over time to rating changes. So there is little evidence of substantial forced selling of bonds that fall below certain ratings thresholds (such as from AAA or from ‘investment grade’ to ‘speculative grade’).

Myth 6

Market prices are better than ratings at indicating default risk

Market-based measures such as bond spreads and CDS prices are useful indicators of market concern about credit risk, but they are not a substitute for ratings.

They reflect the ebb and flow of market sentiment, market liquidity (which for many bonds and CDS contracts is limited) and other technical factors – not just the credit quality of the instrument. And they cover only a small portion of the universe of investable debt.

While markets are volatile and regularly overshoot and undershoot, ratings take a longer-term view of fundamental credit risk and are generally more stable.

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