Ratings agencies are deeply woven into the fabric of the investment community, yet time again their role and operating models fail to be understood, argues Yann le Pallec of Standard & Poor's Ratings Services, who in this article defends the sector.
Credit ratings have been used for more than a century. When companies wish to issue debt in the capital markets, they will often seek a credit rating. That is because many investors choose to use ratings as an input, alongside many others, in their investment process, to help them assess credit risk. Currently, for example, S&P publishes more than 1 million credit ratings on debt issued by borrowers from more than 120 countries around the world.
Despite this, the role of the ratings agencies and their operating models continue to be misunderstood. In particular, some investors wrongly continue to consider credit ratings as investment advice while others view an AAA rating as a guarantee against default. What is more, ratings agencies stand accused of being subject to potential conflicts of interest. As such, it is very important that both investors and issuers do not lose sight of why ratings are useful and understand how to use them appropriately.
Credit ratings agencies provide opinions about the capacity and willingness of borrowers to meet their financial obligations in full and on time. While investors may use these opinions, alongside other factors, in their investment process, one of the most common misconceptions is that ratings work as buy or sell recommendations. Ratings should not drive investment decisions nor be a substitute for independent investment analysis. Of course, an opinion of 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 volatility, which are not addressed by credit ratings.
It is also important to remember that an AAA credit rating is not a guarantee against default. The top 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. Even an issuer or security originally rated AAA might, over time, default – though experience shows that this is rare.
BEFORE THE CRISIS
Indeed, the overall long-term performance of credit ratings has been strong, as measured by their correlation over time with defaults. For example, S&P’s default studies highlight that 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.
Despite this solid track-record, ratings agencies have been criticised, notably with regards to the performance of US mortgage-related securities issued before the crisis. Certainly, this was very disappointing and S&P regrets that, like others, it did not anticipate the scale of the problems that subsequently emerged in the American housing market.
Questions have also been raised about whether the ratings agencies are subject to a potential conflict of interest inherent in the issuer-pays model. The reality is that this business model is the most transparent available because it allows ratings to be provided simultaneously to investors free of charge and maximises public scrutiny of ratings. In contrast, the alternative – the subscription model – charges investors and other market participants a fee to access ratings. This would favour sizable investors with the means to pay for a subscription. In addition, ratings agencies using the subscription model may have more limited access to issuers and their senior management, reducing access to information that can inform forward-looking opinions on creditworthiness.
In fact, no business model is immune from potential conflicts of interest. The key consideration here is how these potential conflicts are managed internally and supervised by regulators, and what system works best for investors. As such, S&P has long established policies and procedures to support the integrity of ratings, including separation of analytical and commercial activities.
Furthermore, ratings agencies are regularly inspected by regulators, such as the European Securities and Markets Authority in the EU and the Securities and Exchanges Commission in the US, which have extensive powers to oversee the quality and transparency of the ratings process. Changes to regulation in recent years have increased the transparency and accountability of ratings and, as a result, strengthened market confidence.
Credit ratings are an integral part of the financial system. The importance of these opinions has increased significantly in recent years as a consequence of the growth and globalisation of the capital markets.
They are valued by international investors because they provide a comparable view of creditworthiness across markets, asset classes and time. To maintain that comparability and the transparency of its ratings, S&P often updates its criteria – for example, in November last year it refined its criteria for assessing industrial and utility companies, following extensive market consultation. The new criteria provide greater insight into the ratings process and enhance the global comparability of corporate ratings through the use of a comprehensive, clear and globally consistent framework. In addition, ratings criteria can be freely viewed on S&P’s public website, where it also publishes extensive information on the reasons for rating actions and what might cause ratings to change in the future.
Indeed, since the financial crisis S&P has spent around $400 million (€288.7 million) reinforcing the integrity, independence and performance of its ratings. In addition, it has brought in new leadership, enhanced its monitoring of global credit risks, and improved its methodologies for rating securities affected by the crisis, including setting higher requirements to achieve AAA ratings. These improvements make ratings more comparable, forward looking and easier to understand.
Yann le Pallec is Europe, Middle East and Africa head of Standard & Poor’s Ratings Services
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