What Credit Ratings Are & Are Not
Credit Ratings Are Expressions Of Opinion About Credit Risk
Credit ratings are opinions about credit risk published by a rating agency. They express opinions about the ability and willingness of an issuer, such as a corporation, state or city government, to meet its financial obligations in accordance with the terms of those obligations. Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation, and the relative likelihood that it may default.
Ratings should not be viewed as assurances of credit quality or exact measures of the likelihood of default. Rather, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue.
A Matter of Opinion
Standard & Poor’s ratings opinions are based on analysis by experienced professionals who evaluate and interpret information received from issuers and other available sources.
Unlike other types of opinions, such as, for example, those provided by doctors or lawyers, credit rating opinions are not intended to be a prognosis or recommendation. Instead, they are primarily intended to provide investors and market participants with information about the relative credit risk of issuers and individual debt issues that the agency rates.
Standard & Poor’s public ratings opinions are also disseminated broadly and free of charge to recipients all over the world on www.standardandpoors.com
Credit Ratings Are Forward Looking And Continually Evolving
While a key component of credit rating analysis is the evaluation of historical data, ratings opinions are designed to be forward looking. In other words, ratings take into account not only the present situation but also the potential impact of future events on credit risk. For example, in assigning its ratings, Standard & Poor’s factors in anticipated ups and downs of business cycles in specific industries as well as trends and events that can be reasonably anticipated.
At the same time, ratings are not static. Rating opinions may change if the credit quality of an issue or issuer alters in ways that were not expected at the time a rating was assigned. For instance, the acquisition or divestiture of a line of business, a change of policy by a government, or erosion in the credit markets that was not foreseen may result in an adjusted rating that reflects this new information.
Credit Ratings Are Intended To Be Comparable Across Different Sectors and Regions
Standard & Poor’s uses the same rating scale across the structured finance, corporate, and government sectors. This rating scale is designed to provide a common language for comparing creditworthiness, regardless of the type of entity or assets underlying the debt instrument or the structure of the financial obligation. This approach is in keeping with Standard & Poor’s goal of providing credit ratings that are reasonably comparable measures of credit quality. This means, for example, in assigning ‘A’ ratings to asset-backed securities, manufacturing firms, or local governments, Standard & Poor’s intends to connote an opinion that they have a comparable level of credit risk. Standard & Poor’s believes that, over the long term, comparable credit opinions are likely to result in reasonably similar average default rates for each rating category across sectors, regions and asset classes. However, as demonstrated in historical studies, default rates in each rating category can fluctuate and such fluctuations are to be expected in the future.
Credit Ratings Do Not Indicate Investment Merit
Standard & Poor’s credit ratings are not intended to indicate the value, suitability, or merit of an investment. They are opinions of credit quality and, in some cases, the expected recovery in the event of default. Credit ratings do not measure performance factors, such as market value or price fluctuations, and they do not address, explicitly or implicitly, whether:
- Investors should buy, sell, or hold rated securities
- A particular rated security is suitable for a particular investor or group of investors
- A security is appropriate for an investor’s risk tolerance
- The expected return of a particular investment is adequate compensation for the risk it poses
- The price of a security is appropriate given its credit quality
- There is, or will be, a ready liquid market in which the security may be bought or sold
- The market value of the security will remain stable over time
While credit quality is an important consideration in evaluating an investment, it cannot serve as the sole indicator of investment merit. In evaluating an investment purchase, investors should consider a wide range of factors, including the current make-up of their portfolios, their investment strategy and time horizon, their tolerance for risk, and an estimation of the security’s relative value in comparison to other securities they might choose. By way of analogy, while reliability may be an important factor in identifying automobiles that drivers will consider owning, it is not typically the single criterion on which drivers base their purchase decisions.
While the initial credit rating assigned to a debt issue, and any subsequent changes to that rating, may affect the price an investor is willing to pay for that debt issue, credit ratings are just one of many factors that the marketplace considers when evaluating debt securities.
Credit Ratings Are Not Absolute Measures Of Default Probability
Standard & Poor’s credit ratings are not exact measures of the probability that a certain issuer or issue will default but are instead expressions of the relative credit risk of rated issuers and debt instruments. In assigning ratings, Standard & Poor’s rank orders issuers and issues from strongest to weakest based on their relative creditworthiness and credit quality within a universe of credit risk. To link any rating to precisely expected default rates would imply a degree of scientific accuracy that the rating process is not intended to provide or deliver.
For example, if the transition and default studies performed by Standard & Poor’s indicate that the annual average default rate of 'BBB' issues was 0.30% historically, this does not mean that a 'BBB' rating is a mathematical prediction of a 0.30% default probability. If a particular set of 'BBB' rated issues suffer a 0.60% default rate, it does not mean those ratings were somehow wrong or inaccurate. In fact, default rates for a specific rating category may fluctuate over time as a result of industry disruptions and economic cycles.
Credit Rating Agencies: What they Do & How They Differ
Rating Agencies Evaluate Credit Risk
As a group, credit rating agencies publish ratings and research about the creditworthiness of issuers and the credit quality of specific debt instruments. Despite general similarities among rating agencies, the types of issuers and issues/securities they rate, the ways in which they assign their ratings and what those ratings signify varies. Some rating agencies limit their work to specific regions, sectors, and/or asset classes, while others maintain global coverage and provide ratings across all sectors and asset classes.
Some major differences among rating agencies, which are explored in the following sections of this module, include:
- The methodologies/approaches they use in assessing risk
- Their scope of coverage
- The business models under which they operate
Some credit rating agencies, including major global agencies like Standard & Poor’s, are publishing and information companies that evaluate the credit risk of issuers and individual debt issues. They formulate and disseminate their opinions for use by investors and other market participants who may consider credit risk in making their investment and business decisions. Partly because rating agencies are not directly involved in capital market transactions, they have come to be viewed by both investors and issuers as impartial, independent providers of opinions on credit risk.
While investors and other market participants are also capable of analyzing credit quality, rating agencies can generally perform credit analyses more efficiently and economically than other firms because they specialize in that activity and devote substantial resources to it.
Standard & Poor’s: A Major Global Rating Agency
Standard & Poor’s is a financial publishing, media, and information company with deep roots in those business segments. It applies many of the same principles that financial newspapers and magazines do in order to preserve their journalistic independence and integrity.
The credit analysis performed by Standard & Poor’s analysts is in some ways similar to the credit analysis that analysts at banks or other financial institutions perform. However, rating analysts sometimes have access to confidential information that is provided by issuers, or investment bankers/arrangers, of structured finance transactions as part of the rating process. Standard & Poor’s also gains a valuable perspective from working on a wide range of credit ratings throughout the world.
Standard & Poor’s performs independent evaluation and reporting of credit risk, and is not otherwise involved in capital market transactions. As a result, Standard & Poor’s credit ratings, which are assigned based on transparent criteria, have long been utilized by capital market participants.
The Origin Of Standard & Poor's Credit Ratings
Standard & Poor’s Ratings Services traces its history back to 1860, the year that Henry Varnum Poor published the History of Railroads and Canals of the United States. Poor was concerned about the lack of quality information available to investors and embarked on a campaign to publicize details of corporate operations. Standard & Poor’s has been publishing credit ratings since 1916, providing investors and market participants worldwide with independent analysis of credit risk.
Rating Methodologies / Approaches
Rating agencies use different approaches in forming and publishing their opinions about credit risk. Some agencies use analysts, some use mathematical models, and some use a combination of the two. As rating agency models differ with regards to their criteria, processes, and ratings definitions, users of ratings should consider such differences if they are using credit ratings as benchmarks.
Analyst-Driven Credit Ratings
Credit rating agencies, such as Standard & Poor’s, that use the analyst-driven approach employ analysts to evaluate and express an opinion on the relative creditworthiness of issuers and the relative credit quality of debt issues. In rating an issuer, such as a corporation or municipality, analysts conduct a review of the financial performance, policies, and risk management strategies of that issuer as well as of the business and economic environment in which the issuer operates. In addition to evaluating financial data, credit analysts typically weigh qualitative information, such as long-term strategies, as they assess the issuer’s ability and willingness to meet its financial obligations in a timely manner.
Rating agencies that use the analyst-driven approach often employ analysts with experience in evaluating the relative credit risk of an entity or security. In addition to their experience with and understanding of the credit markets, analysts are trained to think critically and to evaluate complex business, financial, and accounting issues. Many analysts also bring to bear specializations in specific industry segments and transaction structures in evaluating credit risks attributes.
Model-Driven Credit Ratings
A small number of rating agencies use the model-driven approach, focusing more exclusively on quantitative data that they incorporate into a mathematical model to produce their ratings, which are generally point-in-time assessments. For example, an agency using this approach to assess the creditworthiness of a bank or financial institution evaluates that entity’s asset quality, funding, and profitability based on figures that appear in that entity’s financial statements and regulatory filings. The mathematical formulas used to measure creditworthiness are often proprietary and highly complex.
Standard & Poor's Analyst-Driven Rating Process
Global vs. National Ratings Agencies
Some rating agencies focus only on issuers and issues within a specific country or region, while others provide a global perspective.
Global credit rating agencies, such as Standard & Poor’s, publish ratings and research about the creditworthiness of issuers and the credit quality of debt issues around the world. By applying standardized rating criteria on a global basis, Standard & Poor’s ratings provide a benchmark for assessing the relative credit quality of issuers and instruments. These global scale ratings may be useful to institutional investors who seek geographic diversification in their debt investments while at the same time adhering to internal investment guidelines that require a global benchmark.
National rating agencies can provide a frame of reference different from that of global agencies by concentrating on a particular country and a smaller universe of securities. For example, while global agencies may consider national economic and political risk in their ratings, national agencies may employ a country-specific rating scale. The national scale may be helpful in comparing the relative risk of securities issued in a single country. Global rating agencies may also offer country-specific scales in addition to their global scale ratings, as Standard & Poor’s does.
The Origin Of Standard & Poor's Credit Ratings
Standard & Poor’s Ratings Services traces its history back to 1860, the year that Henry Varnum Poor published the History of Railroads and Canals of the United States. Poor was concerned about the lack of quality information available to investors and embarked on a campaign to publicize details of corporate operations. Standard & Poor’s has been publishing credit ratings since 1916, providing investors and market participants worldwide with independent analysis of credit risk.
History of Standard & Poor's Credit Rating Services
The following timeline provides milestones in Standard & Poor’s ratings history and global expansion:
|1868||Henry Varnum Poor publishes a 200-page book containing operational and financial details on more than 120 railroad and canal companies|
|1916||First credit ratings on corporate bonds and sovereign debt|
|1941||First ratings on municipal bonds|
|1971||First financial strength ratings on insurance companies|
|1973||First ratings on long-term debt of bank holding companies|
|1974||First ratings (non sovereign) issuers located outside the United States|
|1975||First ratings on mortgage-backed securities|
|1984||Began opening European offices|
|1984||First ratings on fixed income bond and money market funds|
|1985||First ratings on commercial mortgage-backed securities (CMBS), and asset backed securities (ABS) (made up of equipment leases, student loans, and other consumer obligations)|
|1986||Opened office in Japan|
|1989||First ratings on collateralized debt obligations (CDOs)|
|1990||Opened office in Australia, through acquisition of Australian Ratings|
|1993||Opened offices in Canada and Mexico, through acquisition of CAVAL|
|1994||Opened office in Hong Kong|
|1995||First ratings on bank loans|
|1996||First ratings on catastrophe bonds|
|1997||Opened offices in Argentina (through acquisition), Brazil, and Taiwan|
|1997||First ratings on synthetic CDOs|
|1998||Opened office in Russia|
|2003||Introduced recovery ratings|
|2004||Opened office in China|
|2005||Investment in India (majority investment in CRISIL Ratings)|
|2008||Opened offices in Dubai, South Africa, and Israel (through the acquisition of Maalot)|
How Agencies Are Paid For Their Services
Credit rating agencies use different business models to generate revenue for the services they provide. One is known as the issuer-pay model and the other as the subscription model.
Under the issuer-pay model, which is the business model used by Standard & Poor’s, rating agencies charge issuers and structured finance arrangers a fee for providing credit ratings. As part of the rating process, these rating agencies obtain from issuers, and incorporate into their opinions of credit quality, information that might otherwise be unavailable to investors and other market participants. Since the issuer pays for the ratings, the agencies can make the ratings widely available to the market free of charge.
Critics of the issuer-pay model maintain there is a potential conflict of interest when rating agencies receive payment from the issuers whose securities they are evaluating.
Some credit ratings agencies use a subscription model and charge investors and other market participants a fee for access to their agencies’ ratings. Proponents of this model maintain that because these agencies are paid primarily by investors rather than issuers, they are therefore not subject to any conflict of interest in their assessment of credit risk.
Critics of this model, however, point out that large investors who subscribe to a rating service, especially sizable investors such as hedge funds who have long and short positions in a variety of securities, may exert an undue influence on the agency’s rating results since it is in the investors’ interest to have the ratings support their investment strategy. Furthermore, critics of the subscription model assert that the ratings are available only to paying subscribers, who are generally large institutional investors. In addition, rating agencies using the subscription model may have more limited access to issuers. Information from management can be helpful when providing forward looking ratings.
How Standard & Poor’s Manages Potential Conflicts of Interest
To protect against potential conflicts of interest when paid by the issuer, Standard & Poor’s has established a number of safeguards.
These measures include, for example, a clear separation of function between those who negotiate the business terms for the rating assignment and the analysts who conduct the credit analysis and provide the rating opinion. This separation is similar in concept to the way newspapers distinguish their editorial and advertising sales functions, since they report on companies from which they may also collect advertising fees.
Another safeguard is the committee process that limits the influence any single person can have on Standard & Poor’s ratings opinions. The role of the committee is to review and assess the analyst’s recommendation for a new rating or a rating change as well as to provide additional perspectives and checks and balances regarding adherence to the agency’s rating criteria.
While Standard & Poor’s maintains a business relationship with the issuers and arrangers of the debt securities it rates, it has policies against structuring an instrument for an arranger or issuer, or consulting with these entities on how to do so.
Also, by adhering to clearly defined standards and making its rating criteria transparent, Standard & Poor’s reduces the risk that credit ratings will be influenced by individual issuers or other parties.
Who Uses Credit Ratings & Why
Ratings & The Capital Markets
While Standard & Poor’s opines and reports on, but does not participate in, capital market transactions, the ratings opinions that it provides may impact the capital markets and the decisions of market participants.
For example, credit ratings may play a useful role in enabling corporations and governments to raise money in the capital markets. Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes. Investors purchase these debt securities, such as municipal bonds, expecting to receive interest plus the return of their principal, either when the bond matures or as periodic payments.
Credit ratings may also facilitate the process of issuing and purchasing bonds and other debt issues by providing an efficient, widely recognized, and long-standing measure of relative credit risk. Investors and other market participants may use the ratings as a screening device to match the relative credit risk of an issuer or individual debt issue with their own risk tolerance or credit risk guidelines in making investment and business decisions.
For instance, in considering the purchase of a municipal bond, an investor may check to see whether the bond’s credit rating is in keeping with the level of credit risk he or she is willing to assume. At the same time, credit ratings may be used by corporations to help them raise money for expansion and/or research and development as well as help states, cities, and other municipalities to fund public projects.
While not an indication of investment merit, credit ratings signal Standard & Poor’s opinion of the perceived risk of a particular debt issue. The greater the credit risk, the higher return investors may expect for assuming that risk. For this reason, credit ratings may be used by both issuers and investors when a debt issue is first issued in the primary markets, and may continue to be used by investors who trade securities in the secondary markets.
Bond/Note Issuance Flowchart
Issuing Debt to Raise Capital
To raise money, corporations and governments may turn to the capital markets instead of borrowing the funds they need from a bank. The markets enable them to borrow money directly from investors by issuing debt, such as a note or a bond. Investors purchase the bonds and expect to receive interest on the par amount of the bond plus a return of the principal either as periodic payments or when the bond matures. The bond details these repayment terms, which can last over several years.
Investors most often use credit ratings to help assess credit risk and to compare different issuers and debt issues when making investment decisions and managing their portfolios.
Individual investors, for example, may use credit ratings in evaluating the purchase of a municipal or corporate bond from a risk tolerance perspective.
Institutional investors, including mutual funds, pension funds, banks, and insurance companies often use credit ratings to supplement their own credit analysis of specific debt issues. In addition, institutional investors may use credit ratings to establish thresholds for credit risk and investment guidelines.
A rating may be used as an indication of credit quality, but investors should consider a variety of factors, including their own analysis.
Investment bankers help to facilitate the flow of capital from investors to issuers. They may use credit ratings to benchmark the relative credit risk of different debt issues, as well as to set the initial pricing for individual debt issues they structure, and to help determine the interest rate these issues will pay.
Investment bankers and entities that structure special types of debt issues may look to a rating agency’s criteria when making their own decisions about how to configure different debt issues, or different tiers of debt.
Investment bankers may also serve as arrangers of special debt issues. In this capacity, they establish special entities that package assets, such as retail mortgages and student loans, into securities, or structured finance instruments, which they then market to investors.
Issuers, including corporations, financial institutions, national governments, states, and cities and municipalities, use credit ratings to provide independent views of their creditworthiness and the credit quality of their debt issues.
Issuers may also use credit ratings to help communicate the relative credit quality of debt issues, thereby expanding the universe of investors. In addition, credit ratings may help issuers anticipate the interest rate to be offered on their new debt issues.
As a general rule, the more creditworthy an issuer or an issue is, the lower the interest rate the issuer would typically have to pay to attract investors. The reverse is also true: an issuer with lower creditworthiness will typically pay a higher interest rate to offset the greater credit risk assumed by investors.
Businesses & Financial Institutions
Businesses and financial institutions, especially those involved in credit-sensitive transactions, may use credit ratings to assess counterparty risk, which is the potential risk that a party to a credit agreement may not fulfill its obligations. For example, in deciding whether to lend money to a particular organization, or in selecting a company that will guarantee the repayment of a debt issue in the event of default, a business may wish to consider the counterparty risk.
A credit rating agency’s opinion of counterparty risk can therefore help businesses analyze their credit exposure to financial firms that have agreed to assume certain financial obligations and to evaluate the viability of potential partnerships and other business relationships.
The ABCs of Rating Scales
A Simple, Efficient Way to Communicate Creditworthiness
Standard & Poor’s credit rating symbols provide a simple, efficient way to communicate creditworthiness and credit quality. Its global rating scale provides a benchmark for evaluating the relative credit risk of issuers and issues worldwide. The ratings serve as a type of shorthand for communicating opinions about credit quality to investors and other market participants.
Standard & Poor’s uses ‘AAA’, ‘BB’, or ‘CC’ to communicate relative credit risk, with ‘AAA’ denoting the strongest creditworthiness and ‘C’ or ‘D’ denoting the weakest, or that a default has occurred. The rating symbols provide a simple way to communicate opinions about creditworthiness.
While a rating scale itself is relatively straightforward—for example, a bond rated ‘AAA’ signals higher credit quality than a bond rated ‘BB’—the assumptions, considerations, and judgments that help to form a rating opinion are different and complex. This complexity results in part from different types of risk factors informing the analysis that range, for example, from a particular issuer’s financial performance and the competitive environment in which it operates to the structure or details of a particular issue. In addition, the rating process factors in events that may occur in the foreseeable future and are likely to affect the credit risk of a particular issuer or issue.
Over time, the overall performance of Standard & Poor’s ratings has helped to establish its rating scale as a good benchmark of relative credit risk. This in turn, has enabled investors and market participants to use ratings as a benchmark and as a second opinion when performing their own analysis.
Standard & Poor’s typically expresses its opinion of creditworthiness in terms of three components:
- The long-term rating
- The outlook on the long-term rating
- The short-term rating, where applicable
Opinions Reflected By S&P's Ratings
View the complete list of Standard & Poor’s Ratings Definitions and a related article on Understanding Standard & Poor’s Ratings Definitions
Investment- & Speculative-Grade Debt
Debt issues that are rated as having higher credit quality are commonly referred to as investment-grade securities. Those that are assessed to have a relatively lower credit quality are often referred to as non-investment-grade, or sometimes speculative grade, securities.
The term “investment grade” initially identified debt securities that bank regulators and market participants viewed as suitable investments for institutions such as banks, insurance companies, and savings and loan associations. Today, however, the term is used more broadly in the investment community to identify categories of issuers and issues with relatively higher levels of creditworthiness and credit quality. Market participants typically look to rating scales to determine thresholds for investment-grade securities.
In contrast, the term “non-investment-grade” is generally used in reference to debt securities where the issue or issuer currently has the ability to repay but faces uncertainties, such as adverse business or financial circumstances, which could increase the likelihood of default, or failure to meet its financial obligations in accordance with the terms of those obligations.
Long-Term Ratings, Ratings Outlooks, and Short-Term Ratings
Standard & Poor’s long-term credit ratings range from a top rating of ‘AAA’, reflecting the strongest credit quality, to ‘D’ for debt issues that are actually in default and for issuers who did not meet their financial obligations or have declared that they cannot do so. The addition of pluses and minuses provides further distinctions within ratings that range from ‘AA’ to ‘CCC’. For example, a ‘AA+’ rating indicates a higher level of creditworthiness than a ‘AA’ rating, while a ‘AA–’ would indicate lower creditworthiness than a ‘AA’ rating.
Standard & Poor’s assigns outlooks, which may be “positive,” “negative,” “stable,” or “developing”, to its long-term credit rate. A positive outlook suggests that the issuer’s rating may be raised, while a negative outlook indicates it may be lowered. Outlooks typically have a six-month to two-year time frame and address trends or risks with the potential, but not the certainty, of raising or lowering a credit rating sometime over the next two years. Outlooks that use the term “stable” indicate that a change is unlikely, though that opinion is not a comment on the stability of the issuer’s financial performance. Those that use the term “developing” describe unique situations where the effect of future events is so uncertain that the rating could either be raised or lowered.
When an event, unexpected change or criteria change occurs that is likely to cause a ratings change in the near term, Standard & Poor’s places the rating on CreditWatch, which replaces the outlook on that rating.
Short-term ratings express opinions about the creditworthiness of an issuer or the credit quality of a debt issue in the near future. As a general rule, short term ratings are used for issues that have maturities of one year or less, such as commercial paper. Long-term ratings are assigned to issues with maturities that are generally more than one year, such as 10-year term bonds or bank loans, or even medium term notes which usually have maturities of 3 to 5 years.
The short-term ratings scale, which has fewer grades than the long-term scale, ranges from ‘A-1+,’ representing extremely strong ability to meet obligations, to ‘D,’ which indicates payment default. The long- and short-term ratings are generally linked to one another: If an issuer’s long-term credit rating is downgraded, the short-term rating may be downgraded as well. Since there are fewer short-term rating grades, each short-term rating corresponds to a band of long-term ratings. For instance, the ‘A-1’ short-term rating generally corresponds to the long-term ratings of ‘A+’, ‘A’, and ‘A-‘.
Standard & Poor's Rating Correlation Scales
Some credit rating agencies also incorporate into their ratings opinions the potential for recovery, which is an opinion about the amount that investors may recover in the event of default. Rating agencies that assess recovery consider the percentage of the instrument’s outstanding principal that an investor can expect to receive back. When used as a rating factor, recovery prospects are an important component in evaluating credit quality, particularly in the evaluation of non-investment-grade debt.
To address the market’s need for recovery information, Standard & Poor’s began assigning recovery ratings in 2003 and the use of these ratings continues to evolve. As of 2008, such recovery ratings were assigned by Standard & Poor’s to secured and unsecured debt of speculative-grade corporate issuers in the U.S., Western Europe, and certain other countries.
These ratings provide a forward-looking analysis based on issuer-specific and deal-specific data, and express Standard & Poor’s opinion regarding prospective loss on debt issues in the event of default. Risk factors include how the debt is structured, the relationship among creditors, the jurisdiction, and how a default would affect the value of the assets.
Standard & Poor’s recovery ratings use a scale of 1 to 6 rather than the letter ratings and express an opinion about the percentage of principal and unpaid accrued interest that investors may expect to receive in the case of default. The opinion is based on a number of different factors, including the rights that investors and/or creditors may have to specific assets, the potential liquidation value of the entity’s assets, and the result of formal bankruptcy proceedings or informal out-of-court restructuring. The recoveries themselves may be in cash, debt, or equity securities of a reorganized entity, or some combination of the three.
The recovery rating scale forms the basis for adjusting the credit rating of an issue up or down relative to the credit rating of the issuer.
Recovery Ratings Scale & Issue Rating Criteria
Other Standard & Poor’s Rating Scales
Standard & Poor’s provides a number of additional ratings scales, including but not limited to: Principal Stability Fund Ratings (for money market funds), Fund Credit Quality Ratings and Fund Volatility Ratings (for bond funds) and Financial Strength Ratings (for insurance companies).
While Standard & Poor’s is a global rating agency, it also provides more than a dozen country-specific national scales for countries, including Mexico, Russia, Kazakhstan, and Argentina, among others. Market participants within those countries may use these rating scales to assess the relative creditworthiness of issuers and debt issues in a given country in comparison only to other issuers and debt issues within that same country. These national scale ratings generally use Standard & Poor's rating symbols with the addition of a prefix to denote the country—for example, ‘AAmx’ signifies a ‘AA’ rating on the Mexican national scale.
Process For Rating Issuers & Issues
Rating Issuers & Issues
Credit rating agencies assign ratings to issuers, including corporations, governments, and public finance entities, that issue debt securities, as well as to specific issues, such as bonds, notes, and structured finance instruments.
Credit rating agencies use their own proprietary rating methodologies for evaluating the creditworthiness of issuers and the credit quality of debt issues. Standard & Poor’s, assigns and publishes ratings at the request of the corporations, governments, or structured finance arrangers, and in some cases will also issue ratings without request.
Standard & Poor’s maintains policies and procedures to protect the integrity of the analytic process. The ratings that Standard & Poor’s assigns are based on transparent, publicly available criteria. Standard & Poor’s provides a rating only when there is adequate information for analysts to perform the qualitative and quantitative evaluations that enable them to form an opinion of credit quality.
In addition, each Standard & Poor’s rating is determined by a rating committee rather than by a single person. This practice is one of the many checks and balances incorporated into the rating process. Standard & Poor’s analysts are not compensated based on the revenue generated by the ratings that they work on, nor do they negotiate fees for such ratings. Similarly, Standard & Poor’s client business managers, who deal with commercial matters such as pricing, contract negotiations, and maintaining client relationships, do not participate or vote in rating committees.
Standard & Poor’s rating process is generally similar for all issuers, including corporations, governments, and financial institutions, though there are some differences, including with respect to rating structured finance instruments. These differences involve the way the process is initiated and conducted, the rating criteria and assumptions that apply, as well as the specific kinds of information that analysts review, particularly the details of the debt issue itself, which are further discussed within this section.
Rating an Issuer
To assess the creditworthiness of a corporate or government issuer, Standard & Poor’s concentrates on the attributes evidencing the issuer’s ability and willingness to repay its obligations in full and in accordance with their terms. To form that opinion, agency analysts weigh a broad range of business and financial attributes relevant to that issuer that may influence the issuer’s ability to repay. For example, credit rating analysis of a corporate issuer typically considers many financial and non financial factors, both qualitative and quantitative. These include, to name only a few: economic, regulatory, and geopolitical influences; management and corporate governance attributes; key performance indicators; competitive trends; product-mix considerations; R&D prospects; patents rights; and labor relations.
Standard & Poor’s uses interactive, qualitative analysis and its analysts typically engage in a dialogue with the issuer’s management to obtain additional information and insight about the issuer’s current position and future plans. In most cases, once Standard & Poor’s has rated an issuer, it tracks, or conducts surveillance of, that issuer over time. Standard & Poor’s may adjust the issuer’s rating if the issuer’s credit risk profile changes in key risk factors, such as market conditions, business prospects and capitalization.
Rating an Issue
In rating an individual issue, Standard & Poor’s evaluates its credit quality and likelihood of default based on current information furnished by the issuer or obtained from other reliable sources. Key considerations include:
- The issue’s terms and conditions and, if relevant, its unique legal structure
- Relative seniority of the issue with regard to the issuer’s other debts and priority of repayment in the event of default
- The existence of external support or credit enhancements (including mechanisms such as letters of credit, guarantees, insurance, and collateral, which are protections designed to limit the potential credit risks associated with a particular issue. Enhancements are a key factor in analyzing structured finance instruments).
In the case of corporate and government issues, the process typically begins with an evaluation of the creditworthiness of the issuer before assessing the details and credit quality of a specific issue.
Rating Structured Finance Instruments
With most structured finance instruments, the issuers are special-purpose entities (SPEs) which are created solely to accumulate and finance pools of assets by selling securities to investors. In forming its opinion of a structured finance instrument, Standard & Poor’s evaluates, among other things, the potential risks posed by the instrument’s legal structure, the credit quality of the assets the SPE holds, and the anticipated cash flow of these underlying assets, as well as credit enhancements that provide added protection against default to some or all of the securities. For more information see Process For Rating Structured Finance Instruments
Standard & Poor's Analyst-Driven Rating Process
Typical Process For a New Corporate or Government Rating
- Contract. The issuer requests a rating and signs an engagement letter.
- Pre evaluation. Standard & Poor’s assembles a team of analysts to review pertinent information.
- Management meeting. Analysts meet with management team to review and discuss information.
- Analysis. Analysts evaluate information and propose the rating to a rating committee.
- Rating committee. The committee meets to review and discuss the lead analyst’s rating recommendation and presentation, including the full analysis and rating rationale, and then votes on the credit rating.
- Notification. Standard & Poor’s generally provides the issuer with a pre-publication rationale for its credit rating for fact-checking and accuracy purposes. Standard & Poor’s may allow for an appeal only if the issuer can provide new and significant information to support a potentially difficult rating conclusion.
- Publication. Standard & Poor’s typically publishes a press release announcing the rating and posts the public rating on www.standardandpoors.com.
Ratings Require Adequate and Reliable Information
Standard & Poor’s may decide not to rate an issue or issuer, or withdraw an existing rating, if it concludes that there is not adequate, timely or reliable information to form an opinion on the creditworthiness of an issuer or the credit quality of a specific issue.
Rating Corporate and Government Issuers & Issues
Request For corporate, financial institution, or government issuers, Standard & Poor’s rating process is typically initiated when the issuer or its representative requests a rating for a particular debt issue.
A Standard & Poor’s client business manager (CBM) typically responds to the issuer’s request and enters into an agreement to rate the issuer and/or issue. All commercial matters are handled by the CBM and the terms and conditions are not negotiable.
When a new corporate or government issuer engages Standard & Poor’s to provide a credit rating on an upcoming debt issue, the agency generally assigns a rating to the issuer, called an Issuer Credit Rating (ICR), which reflects an entity’s overall capacity to meet its financial obligations in accordance with their terms. The agency then assigns ratings to the issuer’s specific debt securities.
Standard & Poor’s typically rates all publicly offered debt securities issued by a rated corporate or government entity, including those securities issued in different countries. For various reasons, including guarantees, insurance, prospects for recovery, etc., Standard & Poor’s may rate an issue higher or lower than the rating assigned to the issuer itself.
Standard & Poor’s Public Finance Ratings Group, typically issues ratings that are issue-specific (e.g., general obligation notes, revenue bonds, school district bonds, or bonds to fund projects), as opposed to ICRs.
S&P's Risk Factors
The Initial Rating Process
The initial rating process for corporate, government, and financial entities typically takes four to six weeks to complete, but can run longer or shorter. This initial process begins when the contract is signed and generally ends with the publication of the rating.
The rating process consists of several discrete steps, as shown in Standard & Poor’s Typical Process For a New Corporate or Government Rating and typically includes a series of ongoing information exchanges between the rating agency and the issuer. These interactions enable Standard & Poor’s to gather the information it needs to conduct its evaluation and form its rating opinion.
The Analytical Team & Rating Committee
Standard & Poor’s assigns a lead analyst and generally a backup analyst to begin the rating process. Standard & Poor’s selects the analysts for each rating assignment based on their knowledge of and experience with a particular issuer, sector, industry, or the type of debt obligation being issued.
To strengthen the evaluation process, Standard & Poor’s appoints a committee of generally five members, including the lead and backup analysts. The role of the committee is to review and assess the lead analyst’s rating recommendation for a new rating or a ratings change, to provide additional perspectives in the analysis, to provide checks and balances against conflicts and undue influence, and to provide consistent application and adherence to the ratings criteria. For repeat issuances, outlook changes, CreditWatch placements and certain other instances, the committee may be smaller, but an individual analyst can never make such a ratings decision on his or her own.
Committee members are chosen for their particular areas of expertise, which might include, for example, accounting or risk management. If the issuer is an international corporation, the committee may include analysts who are familiar with the regions and markets in which the issuer operates. In addition, Standard & Poor’s appoints a committee chairperson who is responsible for overseeing the committee process and making sure that the relevant criteria are applied consistently.
Pre evaluation. Prior to meeting with the issuer’s management, the analysts examine the issuer’s publicly reported financial information and any other relevant information provided by the issuer. This pre evaluation helps analysts identify and define additional information needed from the issuer as well as specific matters the issuer should be prepared to address at the management meeting.
Management meeting. The purpose of the management meeting, which is generally attended by the issuer’s relevant senior executives, is to enable Standard & Poor’s analysts to probe pertinent information in greater detail, including public information as well as other information that may be provided by the issuer. The discussion usually takes place in person at the issuer’s offices, but in some cases can take place at Standard & Poor’s offices, over the phone, or a combination of all of these. At the conclusion of the meeting, Standard & Poor’s will outline the committee process and provide an indication as to how long the process may take. However, the meeting may result in a request for clarification, for additional information, or for continuing dialogue.
Analysis. For corporate and government ratings, analysts typically begin their evaluation by assessing the business and financial risk profiles of the issuing entity (as summarized within the Key Analytical Considerations table below). Analysts also consider comparisons to similar entities, as such comparisons help inform the analysts’ views of the entity in relation to its peers.
In evaluating the financial profile of a corporate or financial entity, for example, Standard & Poor’s analysts may first examine the company’s financial statements, including an evaluation of its accounting practices, focusing on any unusual treatments or underlying assumptions. To further assess a corporation’s overall strengths and weaknesses, the analysts use a number of financial ratios, including those that evaluate profit margins, leverage, and cash flow sufficiency. Analysts may also take into account items that do not appear on a corporation’s balance sheet, such as leases and pension liabilities that can have an impact on the company’s creditworthiness.
In many cases, financial risk factors that are unique to a specific type of issuer or issue play an important role in financial analysis. For example, in analyzing the capital adequacy of international financial institutions, Standard & Poor’s may make adjustments to the issuer’s reported assets to incorporate Standard & Poor’s view of risk levels for each of the issuer’s distinct business lines and for the specific regions the issuer operates within.
In evaluating a government entity, analysts use essentially the same process, though the specific risk factors they consider differ slightly. For example, analysts focus on the economic base rather than business risk, as well as on any potential instabilities or political pressures that may affect the entity’s creditworthiness.
Committee evaluation. The lead analyst presents his or her assessment to the committee, which discusses, questions, and debates the analyst’s conclusions and evaluation of certain risk factors. The final rating assigned by the committee is primarily determined by applying the rating criteria to the information that the analysts have collected and evaluated. However, rather than providing a strictly formulaic assessment, Standard & Poor’s factors into its ratings the perceptions and insights of its analysts based on their consideration of all of the information they have obtained. This process helps the committee to form its opinion of an issuer’s overall ability to repay obligations in accordance with their terms.
The committee reviews and discusses the internal report presented by the lead analyst. This internal document summarizes the main analytical factors and outlines the rationale for the long-term rating, outlook, and short-term rating for a specific issuer. The committee analyzes each subcategory of credit risk, such as an entity’s business and financial risk profiles, and comments on particular strengths and weaknesses that affect the entity’s rating. The final report summarizes the main expectations that were factored into the rating and notes the conditions that might lower or raise the rating in the future.
Notification of issuer. Standard & Poor’s generally notifies the issuer of the rating and outlook, and provides a rationale for the major factors supporting the rating. If an issuer disagrees with the rating conclusion, Standard & Poor’s may allow for an appeal only if the issuer can provide new and significant information to support its point of view. If an appeal is granted, Standard & Poor’s will reconvene the committee, review the new information, and vote again on the rating.
Publication. For public ratings, in most cases, Standard & Poor’s publishes a press release announcing the final rating along with the rationale, distributes it to the media, and posts it on www.standardandpoors.com. To verify that the factual information is correct and that no confidential information has inadvertently been disclosed, Standard & Poor’s may provide the issuer with a copy of its report for a review prior to releasing it to the public. However, if the rating is provided on a confidential basis, the rating is not published and Standard & Poor’s disseminates the rating only to the rated entity.
Key Analytical Considerations
In rating corporate, government, and financial entities and issues, Standard & Poor’s evaluates a broad range of business, financial, and entity-specific risk factors to develop the clearest and most comprehensive assessment of that entity’s creditworthiness.
The following table summarizes the key analytical factors that go into determining those ratings:
|Ratings Type||Principal Analytical Considerations|
||For Corporate Issuers
||For Corporate and Government Issues
Process For Rating Structured Finance Instruments - Key Differences Highlighted
While generally similar to the process used for rating corporate and government issues, the rating process for structured finance instruments differs in some key respects. For example, the analysis in structured finance generally concentrates on the instrument to be issued, rather than starting with an evaluation of the issuer, as is the case with corporate ratings.
In addition, rating structured finance instruments typically involves a different kind of dialogue between analysts and arrangers than does rating corporate or government issues. Typically, in a structured finance transaction, an arranger has a desired rating outcome and will attempt to assemble a pool of underlying assets and structure the transaction to meet the rating agency’s published criteria. There is typically some interaction during the ratings process between the arranger and Standard & Poor’s regarding the application of S&P’s criteria as it relates to the composition of the pool of assets and the structure of the transaction.
The fact that arrangers may alter the structure of their instruments to meet an agency’s rating criteria has led some critics to question whether rating analysts are in essence serving as advisors for structured finance transactions. Standard & Poor’s ratings analysts do not structure transactions or provide consulting or advisory services to arrangers, originators, or other parties involved in structured finance. Standard & Poor’s analysts do not tell an arranger what it should or should not do.
It is important to recognize that Standard & Poor’s arrives at structured finance ratings through the use of criteria and methodologies that are publicly available to all investors and market participants.
The Initial Ratings Process for Rating Structured Finance Instruments
Request. The process typically starts with an inquiry from the originator of the assets to be securitized or from the arranger of the transaction. While a member of the analytical team may receive a request directly, all ratings request are referred to a Standard & Poor’s client business manager (CBM), who handles the commercial matters. The CBM responds to the rating inquiry and generates the ratings engagement letter.
Pre evaluation. An analyst is assigned as the primary analysts (PA), who coordinates all analytical matters. Typically, the PA starts with a review of the preliminary information provided by the originator or arranger regarding the assets it proposes to securitize and the proposed terms and conditions of the securities to be issued. The PA typically discusses with the originator or arranger the transaction type and parameters, criteria applicable to the transaction, timing of transaction documents, and cash-flow models when appropriate.
Based on this dialogue, the originator or arranger may decide not to proceed with the rating. By the same token, Standard & Poor’s may decide at this point not to move forward with the rating if it believes there is not sufficient or reliable information on which to form an opinion of the credit quality of the assets, or if the structure is not well defined.
Analysis. The full analytical process generally begins when the PA is notified by his or her analytical manager that the CBM has received the signed engagement letter. Typically, the PA conducts the evaluation and often works with a backup analyst and others who have previously evaluated similar assets or transactions, including collateral and quantitative analysts where appropriate. To supplement the information previously received, the analyst may ask for more specific information relating to the assets and/or the transaction.
The analyst completes his or her evaluation of the principal analytical considerations (as summarized within the Key Analytical Considerations table), which usually include both the use of quantitative models and consideration of qualitative factors.
For a typical transaction, the analytical process includes the following steps:
- Review of the originator and/or servicer/manager of the assets
- Collateral analysis
- Cash flow analysis
- Review of legal socuments
- Rating committee recommendation
There are specific points at the conclusion of the above noted analytical steps at which the Primary Analysts will provide feedback to the originator or arranger on the results of the analytical reviews. At these points, the originator or arranger may decide to (a) move forward, (b) reconfigure the collateral pool or terms of the transaction and ask for a review of the alternative structure, or (c) decide to cancel the transaction.
As noted above:
- Standard & Poor’s may decide not to move forward with the rating if it believes there is not sufficient or reliable information on which to form an opinion of the credit quality of the assets, or if the structure is not well defined.
- Standard & Poor’s ratings analysts do not structure transactions and do not tell an arranger what it should or should not do.
Rating Committees. The primary analyst forms an initial opinion as to the credit quality of the instruments and recommends the proposed ratings in a meeting with the rating committee.
The rating committee, notification and publishing processes are generally the same for structured finance as they are for rating corporate and government entities as described on this site [Typical Process For A New Corporate Or Government Rating]. However, in cases of public ratings, where a presale report is published, Standard & Poor’s may hold two rating committees. If a preliminary rating committee is held, a preliminary rating will be voted on and published along with a presale report. Even if a preliminary rating committee is held, the final rating is determined by a Final Rating Committee.
As with corporate and government ratings, an internal report is prepared that serves as the basis of the rating recommendation for the rating committee’s decision.
What are Structured Finance Instruments?
Some debt securities are created through a process known as securitization. In essence, a typical securitization involves bundling or pooling of individual financial assets into a structured vehicle and the sale of separate debt instruments, often with distinct priorities or cash flow allocations, to investors. Rather than owning a bond that depends on a corporation or government for payment, investors in typical securitized debt instruments have rights to a portion of the cash flows generated by the pool of underlying assets. The most common assets are mortgage loans, auto loans and leases, credit card receivables, trade receivables, bank loans, and corporate bonds, but many other financial assets that generate a cash repayment stream can be securitized.
Creation of Structured Finance Instruments
Securitization is the technique for creating structured finance instruments, such as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). The formulation of these instruments typically involves three parties: an originator, an arranger, and a special-purpose entity (SPE) that issues the securities.
• The originator is generally a bank, lender, or a financial intermediary who either makes loans to individuals or other borrowers or purchases the loans from other originators.
• The arranger, which may also be the originator, is typically an investment bank or other financial services company that pools the underlying loans into an SPE, which in turn sells its own marketable debt instruments.
• The special-purpose entity (SPE), generally created by the arranger, finances the purchase of the underlying assets by selling debt instruments to investors. The investors, who can select a level of risk they prefer, are typically repaid with the cash flow from the underlying loans or other assets owned by the SPE.
The process of stratifying a pool of undifferentiated risk into multiple classes of debt instruments with varying levels of seniority is called tranching. Investors who purchase the senior tranche, with the highest quality debt and typically the lowest interest rate, are generally repaid first from the cash flow of the underlying assets. Holders of the next-lower tranche, which would typically pay a somewhat higher rate, are paid second, and so forth. Investors who purchase the lowest tranche ordinarily have the potential to earn the highest interest rate the transaction offers, but they also assume the highest risk.
Many structured finance transactions incorporate credit enhancements, which are committed resources that can make up for, or cushion, shortfalls in principal and interest receipts on the underlying assets. Credit enhancements are typically in the form of external support and/or internal enhancements, such as insurance or over collateralization.
Creation Of Structured Finance Instruments
Availability of Standard & Poor’s Criteria
Standard & Poor’s criteria are available to all third parties, originators or arrangers, and investors. In the case of unusual or novel structured finance transactions, Standard & Poor’s may publish its views in presale reports on its website, except in the case of confidential ratings. To view Standard & Poor’s updated criteria, visit www.standardandpoors.com.
|Ratings Type||Principal Analytical Considerations|
|Structured Finance Ratings
(on Cash Flow Securities)
|Note: The above addresses the most common structured finance instruments. Standard & Poor’s also provides ratings on other types of structured finance instruments. For more information on the related criteria, please refer to the Criteria & methodologies section of Standard & Poor’s public web site|
Monitoring Credit Quality
Credit Ratings Can and Do Change Over Time
Credit ratings for issuers and individual issues are not static but can and do change over time. The reasons for the changes vary, and may be broadly related to overall changes in the business environment, or they may be more narrowly focused on circumstances affecting a specific industry, entity, or obligation, such as adverse business results at a corporation or political instability facing a government. As a result, Standard & Poor’s monitors, reevaluates, and if appropriate, seeks to adjust, its ratings based on the best available information.
Standard & Poor’s credit ratings are meant to be forward-looking opinions of the creditworthiness of issuers and credit quality of issues. As such, to the extent possible, they factor in conditions that are likely to affect credit risk, such as the anticipated ups and downs in the business cycle. At the same time, prospective opinions are not an exact science and, while ratings are intendted to be forward-looking, they should not be construed as assertions of absolute default probability but rather as relative indications of credit risk. Among other things, business cycles can vary considerably in duration and magnitude, making their impact on credit quality difficult to assess in advance with certainty.
Equally important, credit ratings and criteria are intended to evolve over time to reflect new and sometimes unanticipated situations. Standard & Poor’s may change or “transition” (i.e., upgrade or downgrade) its previously issued ratings to signify a higher or lower level of creditworthiness of an issuer or credit quality of an issue.
Surveillance: Tracking Credit Quality
After issuing a credit rating, Standard & Poor’s typically tracks developments that might affect the credit risk of an issuer or issue. The goal of this surveillance is to maintain a current rating by identifying matters that may result in either an upgrade or a downgrade of the rating.
Such matters could include changing industry trends, issuer performance, credit enhancements, or other credit risk factors. Analysts review ratings with a focus on potential changes to the key analytical factors that supported the earlier ratings opinion. When appropriate, analysts present recommendations for ratings changes to a Rating Committee for a possible action.
Standard & Poor’s surveillance activities may lead to:
- Changing a rating outlook. This occurs when the Rating Committee determines that there is a one-in-three potential for a ratings change based on trends or anticipated risks that may affect creditworthiness for the coming 6 to 24 months.
- Placing ratings on CreditWatch. This occurs when there is a one-in-two likelihood of a rating change in the near term as a result of an event, a significant and unexpected deviation from anticipated performance, or a change in criteria has been adopted that necessitates a review of an entire sector or multiple issues.
- Raising or lowering a rating.
Standard & Poor’s discloses changes to public ratings, generally with a short explanation, and makes them available at www.standardandpoors.com. Actions may include credit rating upgrades, downgrades, withdrawals, and suspensions, as well as changes in credit rating outlooks and CreditWatch placements and removals.
Type and Frequency of Surveillance
Standard & Poor’s considers a number of different factors in determining the type of surveillance to perform on a particular rating. For example, the frequency and extent of surveillance may depend on specific risk considerations that are relevant to an individual, a group, or a class of rated entities. In addition, the regularity of surveillance may be related to the timing and availability of financial and regulatory reporting, transaction-specific performance information, and other new information from various sources.
For corporate and government ratings, it is routine to schedule periodic meetings with management. These face-to-face meetings with issuers assist analysts in staying apprised of any changes in the issuer’s plans and allow them to discuss new developments, performance relative to prior expectations, and potential problem areas. For structured finance ratings, dedicated surveillance analysts monitor performance data and other pertinent information.
Standard & Poor's Analyst-Driven Rating Process
CreditWatch: The Likelihood of a Rating Change
As part of its surveillance process, Standard & Poor’s may communicate the potential for a credit ratings change by placing the rating on CreditWatch. Ratings for an issuer or issue appear on CreditWatch when, based on Standard & Poor’s analysis, an event or deviation from an expected trend has occurred, or may occur, that is likely to cause a ratings change in the near term, usually within 90 days. Specifically, a CreditWatch listing signifies that Standard & Poor’s believes that a specific rating has at least a one-in-two likelihood of being upgraded or downgraded in the near term.
A variety of events and factors, including mergers, recapitalizations, regulatory actions, unanticipated operating developments, or criteria changes may trigger a CreditWatch listing. While the listing means that the potential for a rating change is substantial in the near term, it does not mean that a ratings change is inevitable. Rather, it indicates that more information or analysis is required before taking action. Whenever possible, the rationale explaining the CreditWatch placement indicates a range of possible ratings outcomes that can be anticipated, particularly the extent of the change, up or down.
Standard & Poor’s may also adjust a credit rating without placing the issuer or issue on CreditWatch beforehand. Standard & Poor’s does not delay a ratings change merely because it has not signaled a potential change on CreditWatch. If all the necessary information is available, Standard & Poor’s changes the rating to reflect the altered circumstances.
Expressions Of Change: Outlook And CreditWatch
Outlooks and CreditWatch use a special vocabulary to convey the likelihood of a ratings change:
• "Positive" indicates a rating may be raised.
• "Negative" indicates a rating may be lowered.
•"Developing" applies to unusual situations where the effect of future events is so uncertain that Standard & Poor's is not yet clear whether it might raise or lower a specific rating.
• "Stable" is used only in outlooks and signals that a ratings change is unlikely, but does not express an opinion that the financial performance of the issuer or issue will necessarily remain stable.
Outlook: Longer-Term View of a Potential Rating Change
Standard & Poor’s also assesses the potential for a ratings change by assigning an outlook to most long-term credit ratings Outlooks have a longer time frame than CreditWatch listings and address trends or risks with the potential, not the certainty, of affecting credit quality. The time frame for an outlook generally is up to two years for high-grade ratings and generally up to one year for speculative-grade ratings. An outlook is not an indication that a rating will be listed on CreditWatch. Outlooks use a similar vocabulary to CreditWatch to signal whether a rating is positive, negative, developing, or stable.
Why Credit Ratings Change
Standard & Poor’s changes credit ratings in response to events or information that has an impact on the credit risk of an issuer or issue, as determined by the rating committee. While ratings upgrades and downgrades occur across the entire credit range, historically they have occurred more frequently in lower-rated categories, reflecting increased volatility in that segment of the credit spectrum. On average, higher ratings generally have been more stable than lower ratings.
If ratings are lowered, it’s Standard & Poor’s opinion that there is a greater likelihood of default. Conversely, if ratings are raised, Standard & Poor’s believes there is less likelihood of default. A ratings change denotes Standard & Poor’s opinion of creditworthiness and is only one factor among others that investors should consider when making an investment decision.
Reasons for Ratings Changes
In some cases, changes in the business climate can affect the credit risk of a wide array of issuers and securities. For instance, new competition or technology, beyond what might have been expected and factored into the ratings, may hurt a company’s expected earnings performance, which could lead to one or more rating downgrades over time. Growing or shrinking debt burdens, hefty capital spending requirements, and regulatory changes may also trigger ratings changes. In addition, Standard & Poor’s may adjust its ratings in response to mergers and acquisitions, or an increase or decrease in projected revenues.
While some risk factors tend to affect all issuers, others may pertain only to a narrow group of issuers and issues. For instance:
- A securitized obligation based on underlying credit card payments may have geographically concentrated portfolios, exposing it to regional slumps that a more diversified pool would dilute.
- The creditworthiness of a government issuer may be affected by changes in the stability of political and economic institutions within its country.
- In the case of corporate issuers that adopt a highly aggressive business model, such as growth through large acquisitions or expansion in unproven markets, the risks associated with their ability to execute this strategy are important factors in assessing their creditworthiness.
Volatility of ratings can be expressed either as the proportion of ratings that change or the frequency of change. Higher ratings, in general, have been more stable than lower ratings. Standard & Poor’s upgraded or downgraded roughly 20% of its corporate credit ratings each year from 1981 through 2007, compared to about 10% for structured finance from 1978 through 2007. However, these percentages can increase during periods of significant and unexpected changes in the credit markets or the business environment. In addition, credit ratings for a specific industry, or for a type of structured finance instrument, can have higher or lower rates of change than the general averages.
For example, when the price of oil declined sharply in the mid-1980s, Standard & Poor’s lowered its ratings on about 75% of rated companies in the oil industry, and some of the ratings were lowered repeatedly. Merger and acquisition activity at the time also weakened credit quality. In 1986, the oil industry’s default rate reached 9.3% of rated companies in the industry. Declining credit quality eventually spread to Texas banks that made loans to energy companies, which led to above-average downgrades for financial institutions within the region.
Standard & Poor’s may withdraw a credit rating at any time. For example, it may withdraw issuer credit ratings when there is not enough information to actively monitor the rating. It also withdraws the ratings on issues that have been repaid in full. In rare cases, credit ratings may also be withdrawn at the request of an issuer, such as when a company has been acquired. In some of these cases, Standard & Poor’s may temporarily suspend rather than withdraw a credit rating if there is an expectation that adequate information will become available and/or the rating is likely to be reinstated. Prior to withdrawing or suspending the rating, Standard & Poor’s will affirm, downgrade, or upgrade the rating.
Ratings Changes and Structured Finance
Historically, structured finance ratings have been relatively stable in comparison to corporate ratings. Yet structured ratings are also subject to circumstances that can result in greater ratings volatility than is typically the norm. This volatility may affect the markets generally, or only certain asset classes.
Ratings changes are generally driven by changes in the credit performance of the underlying assets which back the structured finance instruments. For example, a structured finance vehicle may sell notes worth $100 million and receive an investment-grade rating because there is overcollateralization or a cushion of an additional $15 million in assets in the vehicle.
This overcollateralization or credit enhancement raises the total value of the asset pool to $115 million, with the additional collateral providing a buffer against future adverse conditions. But if the conditions are worse than anticipated, and the underlying assets generate less cash flow than expected, the shortfall will reduce the buffer created by the additional $15 million. As a result, Standard & Poor’s could lower its rating on the related structured finance instruments to reflect the decrease in credit quality of the underlying assets in the pool.
When Ratings Change
Credit rating adjustments may play a role in how the market perceives a particular issuer or individual debt issue. Sometimes, for example, a downgrade by a rating agency may change the market’s perception of the credit risk of a debt security which, combined with other factors, may lead to a change in the price of that security.
Market prices continually fluctuate as investors reach their own conclusions about the security’s shifting credit quality and investment merit. While ratings changes may affect investor perception, credit ratings constitute just one of many factors that the marketplace should consider when evaluating debt securities.
Ratings Behavior: Standard & Poor's Ratings Performance
Ratings Behavior Over Time
Different types of credit ratings have different life expectancies, which can affect how ratings change over time. For example, since corporations and governments can exist indefinitely, issuer ratings tend to have a long life span. In contrast, ratings for individual debt securities and structured finance instruments expire once the debt has been repaid. Short versus long lives of ratings are important when examining ratings changes, since ratings with longer life spans are more likely to experience transitions as they are exposed to a wide array of circumstances over time.
Rating Through Different Business Cycles
For high-grade credit ratings, Standard & Poor’s considers the anticipated ups and downs of the business cycle, including industry-specific and broad economic factors. The length and effects of business cycles can vary greatly, however, making their impact on credit quality difficult to predict with precision. In the case of higher risk, more volatile, speculative-grade ratings, Standard & Poor’s factors in greater vulnerability to down business cycles.
Business cycles can affect individual entities in ways that have a lasting impact on their creditworthiness. For example, a company may accumulate enough cash in an economic upturn to cushion the risks of the next downturn. On the other hand, a downturn could severely deplete a firm’s or local government’s financial resources. While Standard & Poor’s aims to keep ratings forward-looking in order to minimize their volatility and increase their stability, some adjustments are inevitable since information changes over time and future events can differ from expectations.
Comparability of Ratings
Standard & Poor’s seeks to maintain consistency in its rating scale over time. That means that Standard & Poor’s assigns a particular rating to an issuer or issue when it believes the credit risk is similar to that of issuers and issues with the same rating. For example, Standard & Poor’s rates a security ‘BBB’ when its overall risk appears broadly similar to that of securities currently and historically rated ‘BBB’. Generally speaking, a particular rating category is intended to signal a comparable level of credit risk across corporate, government, and structured finance ratings.
Ratings as Measures of Relative Creditworthiness
Historically, Standard & Poor’s ratings in aggregate have been good indicators of relative creditworthiness. Higher ratings have been correlated with lower levels of default, and lower ratings have been correlated with higher levels of default.
Transition and Default Studies
To measure the performance of its credit ratings, Standard & Poor’s conducts studies to track default rates and transitions, which is how much a rating has changed, up or down, over a certain period of time. Agencies may use these studies to refine and evolve their analytic methods in forming their ratings opinions.
Transition rates can also be helpful to investors and credit professionals because they show the relative stability and volatility of credit ratings. For example, investors who are obligated to purchase only highly rated securities and are looking for some indication of stability may review the history of rating transitions and defaults as part of their investment research.
In addition to its studies of three broad market segments—corporate, government, and structured finance—Standard & Poor’s publishes narrower transition and default studies. For example, these studies track local and regional governments separately from national governments and analyze corporate issuers based on their industry classification. The studies also distinguish among different types of structured finance instruments, such as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs).
Standard & Poor’s begins tracking its own ratings as soon as they are initially assigned. Analyzing transition and default rates by vintage, which is the year in which Standard & Poor’s first rates an issue or issuer, has yielded a number of important findings:
Higher Credit Ratings Correlate Positively with Lower Default Rates
Standard & Poor’s transition and default studies support the relationship between higher ratings and lower default rates in each of the three broad market segments. In other words, default rates tend to rise with each step down the rating scale. In addition, studies show that what market participants generally refer to as investment grade ratings
(‘BBB–‘ and above) are associated with lower default rates than non-investment grade ratings
Lower Ratings Are Less Stable Than Higher Ratings
Ratings performance data show that lower ratings are less stable than higher ratings. This means a higher proportion of ‘A’-rated issuers and issues retain their ‘A‘ rating during a specified time period, compared with a smaller portion of ‘B’-rated issuers and issues for that same period.
Ratings Are More Volatile Over Time
Ratings are more volatile over longer time periods. For example, regardless of category, transition rates over a 10 year period show greater volatility than one-year transition rates. The broader range of business conditions that can affect credit quality over the course of a longer period may partly account for this increased volatility.
Standard & Poor’s Transition and Default Studies
Standard & Poor’s transition and default studies have tracked the performance of structured finance instruments since 1974, government issuers since 1975, and corporate issuers since 1981. The agency conducts its transition and default research both globally and regionally based on ratings coverage of issuers in more than 100 countries. Standard & Poor’s makes its Default, Transition & Recovery Studies available on its public web site
Some have questioned our lowering of the U.S. rating last year by pointing to the drop in U.S. government bond yields since the downgrade. This, the argument goes, indicates that the creditworthiness of the U.S. is higher than our rating reflects. That represents a misunderstanding of what a rating is: our opinion about the risk of an entity's failure to pay debt in full and on time. But ratings are not the only consideration that investors factor into their investment decisions
We believe the chance of another recession in the U.S. has risen, while the odds of a true double-dip downturn in the eurozone economy remain high. Indeed, we do not believe the U.S. and European economies will improve substantially in the next year, even under our base-case economic scenarios. With the global economy weakening amid considerable downside risks, we anticipate more challenging credit conditions ahead.
A proposal by European leaders to use the EU's rescue fund, the European Stability Mechanism (ESM), to directly recapitalize failing banks could be more positive for the ratings on sovereigns than on banks. This is because direct equity injections by the ESM into eurozone banks would likely come with conditions, which could make government support for banks less likely. Ultimately, better supervision as well as an effective resolution framework could be a more successful way of reducing the effect of bank creditworthiness on sovereigns.
The events in the U.S. over past few years have caused many in the mortgage market to re-think their approach to assessing RMBS. We are updating our criteria to better reflect changing credit risk of the U.S. RMBS transactions we rate. These adjustments will help highlight the differences in credit quality among the outstanding issues and increase the long-term stability of our ratings following the implementation of the criteria.
Given the importance of Europe as a market for American goods and services, a prolonged economic downturn in the region would likely have material repercussions for revenues of U.S. companies in some major manufacturing sectors. The combined GDP for the eurozone and the U.K. was $10.6 trillion last year, highlighting the importance of the region as an economic block in the world economy. This places the region's output close to that of the U.S. and its GDP of $11.3 trillion.
Following some recent bankruptcy restructurings, lenders are recovering amounts far below par on senior unsecured bonds. Recoveries averaged 33% in 2010 and 2012 (through May)--significantly lower than the long-term average of 43%. Several senior unsecured bond instruments associated with issuers that recently emerged from bankruptcy, such as General Maritime Corp. and The Great Atlantic & Pacific Tea Co., have generated recoveries of less than 5% of the principal amount.
U.S. economic growth slowed during the second quarter, according to various indicators. This loss of momentum is factored into our economic forecast. In addition, we have increased our probability estimate of recession within 12 months to 25% from 20%, where it had been since February 2012. In so doing, our economists notched down their forecast of several drivers of the state and local government credit environment. These developments have implications for both periods of our current sector forecast: calendar years 2012 and 2013.
We believe there's still a need for municipal bond insurance, particularly for smaller, less-frequent issuers and small retail investors. The bond insurance sector has the potential to grow, but it will be of a different profile than it was a decade ago. We expect the overwhelming amount of business underwritten by the insurers to be U.S. public-finance par.
The private student lending industry has undergone significant change following Congress's 2010 elimination of the Federally Guaranteed Federal Family Education Loan Program. Because of that, plus the sharply increasing costs of education, the high debt students are incurring, and diminished investor demand for private student loan asset-backed securities, private student lenders have shifted their strategy.
U.S. student debt has quietly grown an average of more than 10% annually to nearly $1 trillion since 2003, eclipsing auto loan and credit card debt for the first time in 2010. The federal government's takeover of most student lending looms large, even as some are calling into question the value of a college education. Students are confronting rising college costs even as employment opportunities continue to diminish. The result is that many students graduate with more limited means to pay off larger debt.
The 2011 medians for U.S. not-for-profit health care systems were stable compared with a year earlier and have in many cases returned to 2007 pre-recession levels following the 2008 and 2009 lows. The broad stabilization in the fiscal 2011 ratios was evident across most metrics and at virtually all rating levels, although there were some changes at individual rating levels. The median trends highlight management's continued focus on improving the balance sheet and, to the extent possible, the income statement.
The median ratios of U.S. not-for-profit stand-alone health care providers were generally steady in 2011 apart from some modest improvements and a few declines. The rating and outlook distributions remained comparable with the prior year. Balance-sheet metrics inched up and were generally at or near pre-recession highs due to good cash flow and lower-than-historical capital spending. Earnings and coverage ratios were stable, with most rating levels seeing only slight changes from a year earlier.
The negative outlook reflects the potential for a downgrade if shortfalls in Greece's 2012 deficit and arrears targets established under the current EU/IMF program are not met by new funding or other relief from members of the Troika (the EU, European Central Bank, and IMF). We see the likelihood of shortfalls, due to election-related delays in the implementation of budgetary consolidation measures for the current year, as well as the worsening trajectory of the Greek economy.
So far this year, the number of new CLO transactions has surged. As the number of new rated CLOs climbs, several trends have emerged that differentiate these deals from their pre-crisis counterparts. For example, post-crisis CLOs generally have higher levels of subordination providing credit support to the senior-most notes. In addition, newer vintage CLOs contain provisions that intend to provide clarity with respect to certain issues and behaviors that arose during the credit crisis of 2008 through 2010.
After a short period of turbulence in the U.S. leveraged finance markets, renewed investor thirst for yield is once again sustaining solid issuance of speculative-grade nonfinancial corporate debt--at least for the time being. Speculative-grade issuance was remarkably strong in the first half of last year, reflecting investor appetite and greater confidence in corporate credit quality. However, credit risk remains in the leveraged finance market considering the current fragile state of the economy.
With the Olympics having just ended, I can't help but think that the U.S. economy is starting to look like a ping-pong ball. Last month, we were disappointed with weak jobs data. But this month, employment is looking a little bit better: The economy created 163,000 jobs in July, according to the Bureau of Labor Statistics. In addition, retail sales surged 0.8%, and the gains were broad-based. That came after three straight months of declines, even when we exclude gasoline sales. Still, the recovery faces some strong opponents.