Relying on credit rating agencies

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CRAs evaluate security’s risk of default

Credit rating agencies (CRAs) have recently come under intense scrutiny. After watching many highly-rated commercial debt securities become worthless several years ago, markets are now questioning the quality of CRA decisions to either downgrade or affirm the ratings of sovereign debt. In the GCC region, ratings agencies currently have a limited role since GCC governments are not aggressive fund raisers in international markets. However, given their importance in pricing and
other functions, as well as measuring market confidence, the credibility of rating agencies is important for the development of GCC bond markets which have been clocking steady growth in recent years. The total value of bond issues raised increased from $20 billion in 2003 to $81billion in 2009 before tapering off to $63 billion in 2010. However, much of the local bond issues (both sukuks and conventional) largely go unrated. There have also been instances where corporate rating has come under severe criticism by the “rated” for poor and misplaced judgment, especially when there is a down grade. In this article, Stephen M. Horan, CFA, CIPM, Head, University Relations and Private Wealth at CFA Institute, and Raghu Mandagolathur, President of CFA Kuwait, discuss the role of CRA’s in the development of regional bond markets. — Editor



By Stephen M. Horan and Raghu Mandagolathur


Question: What is the scope of responsibilities of credit rating agencies?

Answer: A primary function of CRAs is to evaluate a security’s risk of default and the relative magnitude of loss should default occur, rather than its liquidity risk, price volatility or fundamental value. CRAs do not set out to predict future valuation changes from fluctuations in interest rates. CRAs also encapsulate whether a bond issue’s rating is likely to be upgraded or downgraded in the future in a “ratings outlook” - this is the plus or minus that is attached to the rating score.



Q: What is unique about rating sovereign debt?

A: In rating sovereign debt, CRAs look at both economic and political risks. Economic risks include, amongst other things, the existing debt burden, growth prospects and fiscal flexibility whilst political risks include, amongst other things, leadership stability, consensus on economic policy objectives and barriers to global trade. Ratings depend on whether sovereign debt is denominated in local currency or foreign currency. This is because governments can often generate enough local currency to nominally meet local currency obligations using open market operations (or quantitative easing). Printing currency in this way has obvious inflationary implications and one agency, Standard & Poor’s, does consider the risk of implied default through a devaluation of the currency.



Q: What are the implications for Middle East versus Eurozone credit risk?

A: GCC countries, although pegged to the dollar, have independent currencies and a measure of monetary discretion. Eurozone countries issue debt in a common currency over which they have little to no monetary control. As a result, their ability to implicitly default through a devaluation of the currency is limited. Any default would have to be comparatively explicit. Nominal default rates on debt denominated in foreign currencies are historically higher than those on debt denominated in local currencies. But for these sovereigns the built-in inflationary guardrails of a foreign currency debt can ameliorate one source of credit risk leading to a higher rating and lower cost of debt.



Q: Do CRAs predict defaults well?

A: Studies show that poorly rated debt defaults more frequently than highly rated debt. Unfortunately, rating changes tend to lag valuation changes. A more forward-looking estimate of the probability of default is the spread implied by collateralized default swaps which investors purchase to protect from the probability of default. By this measure, the relative probability of default by the United States is relatively low and stable with an annual probability of only about 1.3 percent, even after its recent downgrade. In contrast the risk of default by France is more than twice as high at over 4 percent, despite its triple-A rating being recently affirmed. By comparison, the risk of default for Egypt and Italian debt is about 71/2 percent.



Q: What improvements could be made to the CRA process?

A: Since the financial crisis of 2008, CFA Institute is striving for greater accountability and more effective oversight of CRAs and greater due diligence of the underlying loans they are rating. These efforts include addressing conflicts of interest and lack of competition in the credit rating industry that allowed issuers and CRAs to collaborate on ratings for mortgage-backed securities.



Q: What should fund managers take away from this?

A: Monetary, fiscal, political, and currency considerations make rating sovereign debt more complex and nuanced that corporate debt. Fund managers can better interpret sovereign credit ratings by understanding the nuances and limitations of the CRA process.