Michael Petit of Standard & Poor's explains the main features and characteristics of credit ratings, and looks at their application for investors.
Date: Dec 2011
They are not recommendations to buy or sell, he explained, so are not a judgment on the quality of a company.
Assessing the quality of a credit rating
It isn’t possible to assess the quality of a rating individually, said Petit, because the outcome of the rating assessment is a binary outcome, so either a business entity or debt instrument meets expectations and payments are made, or it doesn’t and they aren’t.
It is only possible to judge this by looking at the pool of ratings, including incidents of past default within that representative pool, he said.
If, after going down the rating spectrum, the incidents of default go up, then the work of the credit rating agency has been good, he explained. On the other hand, if there is a poor ranking of the incidents of default, then the credit rating agency has not done a good job.
Implications of good and bad ratings
Petit said Standard & Poor's has a track record through default studies to show that it has generally done a good job, with an exception inevitably being US housing sub-prime-related securities and collateralised debt obligations from 2005 to 2007.
In general, however, he said investors look at the firm as a sounding board for their own assessment of relative credit risk, as one part of their investment decision.
Changings in the ratings process
Since the credit crisis in 2007 and 2008, for some asset classes, Petit said Standard & Poor's has changed its criteria, for example US housing, where it has changed its assumptions about prices and correlations.
But in general, the main changes have been in relation to increased transparency about assumptions, and trying to be even more rigorous about musings on credit ratings, he explained.
This enables any interested party to review the firm’s methodology and agree or disagree with its credit ratings.
Potential pitfalls of credit ratings
According to Petit, there is a danger that credit ratings get interpreted as a recommendation to buy or sell, or as a gauge of the safety of a particular investment.
At the same time, while there are different ratings and rating agencies, Petit said there is a lot of consistency among the three global credit rating agencies.
In addition, there are a lot of local credit rating agencies, particularly in Asia, assessing relative credit risk within their domestic capital markets. Given that investors tend to have a home bias, Petit said they want an assessment of risk on a scale that represents their investable universe, so having a AAA that in the international rating world would perhaps be a speculative grade rating makes sense in a domestic context.
Investors must therefore realise that the sample of comparison is different, so ratings are not comparable, explained Petit.