Credit Ratings

Lower interest rates have made it difficult for investors seeking income.  Investors have been confronted with a range of opportunities all offering different returns and of course different levels of risk.  The difficulty for retail investors is how to compare these different opportunities in terms of the level of return offered versus the level of risk.  A simple way make this comparison is for investors to look to a security’s credit rating.

All investments entail credit risk; that is why investors are paid a return.  The higher the credit risk, generally the higher the return (or so it should be), with the level of risk defined by the likelihood that investors will have their principal returned and interest will be paid.  If the security or structure is sufficiently robust, a credit rating might be assigned by a recognised ratings agency such as Standard and Poor’s, Moody’s or Fitch.  This allows investors to make a relative assessment as to the credit worthiness of the issuer or specific security.

Detailed below are the broad ratings categories with simplified definitions as defined by Standard & Poor’s:

Ratings definitions (simplified)

So in simple terms, whenever an investor makes an investment they are paid for accepting the credit risk of the borrower.  This is the case no matter if it is a single company issuing the security, or where the security is structured in some way such as CDOs where we look through to the quality of the underlying companies and the first-loss investor protection embedded in the structure.  In fact before we worry too much, it should be remembered that we are taking credit risk whenever we deposit money in a bank or building society or even invest in a Government bond.

Securities with a credit rating of BBB or above are deemed to be investment grade and so offer investors a higher degree of comfort that their principal will be returned and that interest will be paid in a timely manner.  Ratings below this do not mean that an issuer is necessarily high risk, but the lower rating tells investors that securities with sub-investment grade ratings are more vulnerable to financial pressures.  It should be noted that many well known companies listed on the ASX and other global exchanges are not rated investment grade, but still receive solid investor support.

In the real world companies default; but history tells us that investment grade rated companies default much less often than non-investment grade companies.  This is simply a function of their financial strength and their ability to endure tough times or withstand unforeseen events.

The following stylised table shows how likely it is that a rated entity will default over the periods 1 – 5 years.

Source: Standard & Poor’s/ABN AMRO Morgans

Two things are evident from the above chart, firstly that the probability of default falls the shorter the time to maturity and secondly the likelihood that a company will default falls dramatically the higher the credit rating.  This data shows that for a CCC credit there is around a 40% chance that it will default on its obligations over a 5 year period, but this risk falls as we move closer to maturity.  Investment grade rated credits though improve exponentially.  The chart below focuses only on the investment grade rated categories (BBB- and above) and highlights this point.  It should be noted that these numbers do change slightly from year to year and through prolonged economic cycles, but the table does highlight the salient points.

Source: Standard & Poor’s

The other factor to consider is what happens in the event that an investment grade rated company defaults. Because they have much stronger balance sheets than non-investment grade rated companies, then should they default they can be expected to have some residual value after secured creditors have been paid.  We know that as we move down the capital structure from senior debt to equity, the likelihood of recovery of monies decreases dramatically with equity holders usually seeing no return.  This is why banks concentrate their lending at the senior debt level.  The recovery value determines the likely return to unsecured creditors of the company.  Standard & Poor’s tracks the likely recovery rates for various rated entities, and for structured transactions assumes that on average the expected recovery rate will sit around 30% or 30 cents in the dollar for investment grade rated entities.  This takes into account many factors including country of origin, the sector companies operate in, the legal framework and so on.

There are a range of investments where the use of credit ratings is particularly useful such as hybrids, bonds and structured investments.  ABN AMRO Morgans has a range of publications available to clients which explain this in more detail.

In conclusion, we can see that credit ratings are a useful tool that allow individual investors to assess the level of credit risk between different investment opportunities and determine whether they are suitable to their personal circumstances.  For further information you should speak with a licensed adviser who understands ratings and their application.

Steven Wright is Director of Fixed Interest ABN AMRO Morgans Limited.  He can be reached via the ABN AMRO Morgans website - www.abnamromorgans.com.au.

This article has been prepared by ABN AMRO Morgans Limited and licenced to ASX. This material is educational and it is not intended to constitute financial advice. It has been prepared without taking account of any person's objectives, financial situation or needs and because of that, any person should, before making an investment decision, consider the appropriateness of the advice having regard to their objectives, financial situation and needs.

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