Yann le Pallec at S&P’s Ratings Service identifies 10 biggest misconceptions
Yann le Pallec, EMEA head of Standard & Poor’s Ratings Services, has addressed 10 of the most common misconceptions about credit ratings.
1: Credit ratings tell me if I have a good investment
Ratings are an opinion about the capacity and willingness of a borrower to meet its financial obligations. They are not buy or sell recommendations, nor are they substitutes for independent investment analysis. While creditworthiness is often a key consideration for investors, there are a number of other considerations not addressed by ratings; for example, market price, liquidity and investment strategy. The performance of European securitised bonds early in the financial crisis illustrates this point – the market price of many issues fell sharply, even though the asset class experienced a relatively low level of defaults.
2: High credit ratings, such as “AAA”, are guarantees against default
Ultimately, an “AAA” credit rating means that, in S&P’s view, the issuer has a stronger capacity to meet its financial commitments than other more lowly rated borrowers – it is not 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.
3: A credit rating is a poor indicator of default risk
In fact, correlations between credit ratings and rates of defaults are strong, historically. Only 1.1% of companies rated investment grade have defaulted within 5 years since 1981, compared to 16.4% of companies that were rated sub-investment grade. And every sovereign borrower to default in the last 40 years was given a sub-investment grade rating at least a year prior.
We regret that we – like others – did not anticipate the scale of the problems that emerged in the US housing market. As a result, the performance of many US mortgage-related securities issued before the crisis has been very disappointing.
However, ratings have a strong track record elsewhere. Extensive data on the historical performance of ratings is available from a number of sources, such as regulators and ratings agencies themselves. It shows that default rates generally rise with each step down the scale and that higher ratings correlate to greater credit stability.
4: Markets ignore ratings
It is true that market prices can and do diverge from ratings. Of course, this is because markets are driven by many factors beyond credit risk. For many years before the recent debt crisis in Europe, 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). In recent years, sovereign bonds spreads have moved closer to ratings.
Indeed, studies by the IMF and others suggest that markets react more to changes in rating Outlooks or other forward-looking signals from ratings agencies, rather than actual downgrades or upgrades.
While ratings are not short-term investment signals and should not be the driving factor behind investment decisions, many investors do value them as an independent and comparable benchmark of credit risk. As such, many investors choose to make use of ratings as one of many inputs in their investment process, or to screen possible investments.
5: Credit ratings destabilise markets
Sharp market movements are sometimes blamed on ratings, even if many other factors are driving investor behaviour – including investors’ own credit risk analyses.
In reality, ratings are far more stable than market prices. Ratings can and often do change during any credit cycle, but the changes are broadly incremental.
Meanwhile, investment managers usually have the flexibility to respond to rating changes with due consideration over a period of time. And there is scant evidence of significant forced selling of bonds downgraded below certain ratings (such as from AAA or from “investment grade” to “speculative grade”).