Introduction to Bond Rating Agencies

More often than not, we read on news regarding countries or corporations being rated and issued with a rating opinion, stating the assessments as to the credit profile of countries and corporate entities. The names of S&P Global, Fitch and Moody’s are commonly heard of and widespread. Investors might have these questions in mind when they come across this headline such as Who is Fitch? What does it imply to the country or corporation or even to investors themselves? In substance, are they important to us?

What are Credit Ratings

Credit ratings are the assessment conducted by recognized rating agencies to evaluate the credit quality of the issuer in terms of its ability to repay principal and make interest payments in full and on time. These are opinions about the creditworthiness of the issuer and its relative probability of default, so to speak. Each rating agency has its methodology in deriving their credit opinions and addressing with a specific rating scale, which is unique letter-based scores.

Importance of Credit Ratings

Before tapping the bond market, bond issuers such as governments, financial institutions and corporations may be assigned a credit rating by the rating agencies. Credit ratings help to facilitate the process of issuing and purchasing bonds and other debt issues by providing an efficient, widely recognized, and long-standing measure of relative credit risk. Credit ratings are generally assigned to issuers and debt instruments.

Investors, both institutional and individual, use rating opinions as their screening device to evaluate their investment decision based on their risk tolerance level and investment objectives. Issuers, on the other hand, may use rating opinions as a bridge to communicate with potential investors and thus, enlarge their universe of investors.

Furthermore, ratings can also be used to benchmark the credit risk of the debt issue. With that, financial intermediaries like investment banks would be able to structure the specific debt issue as well as determine the interest rate they offer for the new debt issue. A poor credit rating indicates that the debt issue has a higher risk premium, and this prompts an increase in the interest rate charged to the debt issuer with a low credit rating. The reverse is also true; A good credit rating allows borrowers to raise funds at a lower interest rate.

The Big 3 International Credit Rating Agencies

In the United States, there are 3 primary bond rating agencies: Standard and Poor's Global Ratings, Moody's Investors Service, and Fitch Ratings. They have dominated the international credit rating industry for decades, controlling 95% of the rated bond space as of 2013. Most of the rated bonds carry a rating provided by one of them. These agencies conduct financial analysis on the issuer and its debt issue according to their methodology to determine the issuer’s credit quality and assign a credit rating to it. Each agency uses a unique letter-based rating system to convey its ratings opinions to investors effectively and efficiently.

1.  Standard & Poor’s (S&P) Global Ratings

It is the oldest credit rating agency with more than 150 years of experience in rating . Being one of the three Nationally Recognized Statistical Rating Organizations (NRSRO) accredited by the U.S. Securities and Exchange Commission,the company covers more than one million credit ratings on sovereigns, financial institutions and corporates, structured finance entities, and infrastructure. The main goal of the S&P credit rating is the assessment of a security’s default probability. With their rating opinions and risk research that are crucial to translating complexity into clarity so that market participants can make informed investment decisions.

(Source: S&P Global Website)

2.  Moody’s Investors Service

Moody’s is another leading credit and bond rating agency accredited by NRSRO. It contributes credit ratings, risk and research analysis to protect transparency and integrity of financial markets. The company covers more than 130 sovereign nations, 11,000 corporate issuers, 21,000 public finance issuers, and 76,000 structured finance obligations. In their belief, a credible and independent credit ratings and research help improve the efficiencies in bond markets and more importantly, stay investors current with a comprehensive view of global debt markets and navigate the safest path through market volatility.

(Source: Moody's Website)

3.  Fitch Ratings

Fitch is the smallest credit rating agency among the “Big Three” agencies. The firm fuels rating coverage and insightful research across global markets and macroeconomic, including corporations, sovereign entities, financial institutions such as banks, leasing companies and insurers, and public finance entities. Similar to S&P, Fitch introduced the “AAA to D” rating scale to evaluate the relative of default or recovery for issues, which has become the most common grading scoring system for credit risk assessment.

(Source: Fitch Website)

Credit Rating Agencies in Malaysia

Both agencies are registered with SC upon its fulfilment of requirements set out in the SC's Guidelines on Registration of Rating Agencies:

1.  RAM Rating Services Berhad (RAM Ratings)

As the leading and largest credit rating agency in Malaysia and South-East Asia (ASEAN), it was established by Bank Negara Malaysia in 1990 to support and develop the domestic bond market. It is also the world’s leading rating agency for securities issued under Islamic principles (Sukuk). The rating portfolio encompasses corporates, sovereign nations, financial institutions, insurance companies, project finance and structured finance obligations.

(Source: RAM Website)

2.  Malaysian Rating Corporation Berhad (MARC)

Since its establishment in 1996, the agency has completed more than 850 ratings as of 28 February 2021, encompassing sovereign and corporate debt ratings, project financing ratings, structured finance ratings, insurer and issuer financial position ratings and so forth. MARC recently ventured into new business segments, providing the market with up-to-date data analytic offerings, as well as risk framework solutions and advisory.

(Source: MARC Website)

Types of Ratings

Credit ratings assigned by rating agencies are forward-looking opinions with reference to relative credit risks of financial obligations and ability of an issuer to meet financial commitments to a specific class of financial obligations, or a specific financial program (including ratings on medium-term note programs and commercial paper programs). Apart from that, they further take into account the value of additional collateral, creditworthiness of guarantors or insurers, and other forms of credit enhancement, as well as the currency in which the bond is denominated.

1.  Issuer Default Ratings

Opinions of the overall creditworthiness of the issuer, emphasizing on the issuer’s capacity and willingness to meet its financial commitments. Issuer Ratings do not incorporate any specific financial obligation, such as guarantees, and apply only to specific (but not to all) senior unsecured financial obligations and contracts.

2.  Long Term Debt Ratings

Opinions of relative credit of debt obligations with original maturity of more than 1 year. These ratings address both the likelihood of a default on contractually promised payments and the expected financial loss suffered in the event of default.

3.  Short-Term Debt Ratings

Opinions of relative ability of debt issuers to fulfil short-term financial obligations of not more than 13 months and address both on the likelihood of a default on contractually promised payments and the expected financial loss suffered in the event of default.

Rating Scales

Credit ratings do not deal with any risk other than credit risk. In other words, credit ratings do not measure the risk of market value loss owing to interest rates movement, liquidity of the bonds or other market risk. Nonetheless, market risk may be considered to the extent that it influences the ability of an issuer to pay or refinance financial obligations.S&P and Fitch Ratings may modify the ratings from ‘AA’ to ‘CCC’ by the addition of a plus (+) or minus (-) sign while Moody's appends numerical modifiers 1, 2, and 3 from ‘Aa’ to ‘Caa‘ to show relative standing within the major rating categories.

MARC may modify the ratings from ‘AA’ to ‘B’ by the addition of a plus (+) or minus (-) sign while RAM RAM applies 1, 2 or 3 in each rating category from ‘AA’ to ‘C’ to show relative standing within the major rating categories.

Furthermore, RAM and MARC may carry suffixes to certain corporate debt ratings when such bonds are protected by external credit enhancement or or third party guarantees. For instances, Long-term and short-term bond ratings may be given with (bg) for bank-guarenteed issues, (cg) corporate-guarenteed issues, (fg) financial guaranteed insurer such as Danajamin Nasional Berhad and other supprts (s). In essense, the credit risk of such bonds is improved by providing reassurance to the crediworthiness of the bond issuer

Investment Grade Bonds

Investment-grade bonds are always seen as safer and more stable investments that are tied to corporations or government entities that have better ability to meet financial obligations. These are bonds issued by companies that

have superior financial standing. They are rated from AAA to BBB- (S&P, Fitch and MARC), Aaa to Baa3 (Moody’s), or AAA to BBB3 (RAM).

(Sources: S&P Global Rating Scale, Moody's Rating Scale and Fitch Rating Scale)

(Sources: RAM Rating Scale and MARC Rating Scale)

Non-Investment/ Speculative Grade Bonds

These are issued by corporations that have lower creditworthiness, this could be due to weaker earnings or higher leverag companies. These bonds are accorded credit ratings of BB+ or lower (S&P, Fitch and MARC), Ba1 or lower (Moody’s), or BB1 or lower (RAM). Sometimes known as “high-yield bonds” or even “junk bonds”. It is important for investors to keep things in perspective despite the name which suggests high risks. For example, statistics from S&P over the last 40 years (1981 – 2020) indicates that while the weighted average annual default rate (chance that a randomly selected bond is defaulting in a given year) of “A” rated bonds is 0.05%,  for “BB” rated bonds it is 0.63%. Instead of depending on the rigid split between investment vs speculative grade bonds, investors are encouraged to study annual corporate default statistics published by rating agencies and determine if such risks are acceptable. Investors should also note that

annual default rate could change from one year to another. For example, during years of recession such as 2008-2009 and 2020, the default rate will tend to be higher. The changes from one year to another also tend to be more significant the lower the credit ratings. For example, according to S&P statistics, annual default rate for “AA” rated bonds increased from less than 0.005% to 0.38% from 2007 to 2008, for “BBB” rated bonds it increased from less than 0.005% to 0.49% while “B” rated bonds jumped from 0.25% to 4.11% over the same period.

(Sources: S&P Global Rating Scale, Moody's Rating Scale and Fitch Rating Scale)

 (Sources: RAM Rating Scale and MARC Rating Scale)

Rating Outlook

The rating outlook is an assessment to forecast the potential for a direction and rating change of a long-term credit rating over the medium to longer term. In determining a Rating Outlook, consideration is given to any changes in the economic and/or fundamental business conditions.

Typically, the time frame for an outlook is up to 2 years for investment-grade and up to 1 year for non-investment grade as non-investment grade may be subject to more volatility in terms of refinancing risks, liquidity issues and covenant triggers.

Rating Differences Between Credit Agencies

Quite often, an issuer would have more than one ratings. In this case it is not uncommon for rating agencies to differ from each other. That being said, the differences in rating are typically not more than one to two notches. For example, it is possible that an issuer rated as Aa1 by Moody’s could be rated AAA by S&P and AA by Fitch. This is also why investors should not depend solely on credit ratings for investment decision.

Another point to note is ratings given by local rating agencies such as RAM and MARC is not equivalent to ratings given by the “Big Three”. For example, Maybank could be rated as AAA by RAM, but it will likely get a rating of “A-” or even “BBB+” by Moody’s, S&P or Fitch. This is because the credit rating of a company is typically less than that of the sovereign country it is based in, and Malaysia’s sovereign rating is rated as A3, A- or BBB+ by Moody’s, S&P and Fitch respectively.

Global Corporate Default Rate across Ratings

It has been statistically proven that in any given year, everything else equal, higher corporate ratings tend to indicate  lower annual default rates. According to the “2020 Annual Global Corporate Default And Rating Transition Study” by S&P Global Ratings, the global corporate default cases in 2020 has risen due to the Covid-19 pandemic compared to 2019. The corporate defaults were mainly limited to the lowest rating categories.
There were 198 companies (2.74%) that defaulted under speculative-grade categories of which47.48% were from the grade of “CCC/C”. Investment-grade bonds, on the other hand, had zero cases of default in the year 2020 and the annual default rate of “AAA” rating bonds has consistent track records of less than 0.005%since 1981.

 

That being said, it is important to note that the annual default rate can only be applied to any particular year. An investor who holds a “AAA” rated bond over a period of say 5 years could still see her AAA rated bond being downgraded and subsequently defaults. Statistics from the abovementioned report indicates that over a 5 year period, a randomly selected “AAA” rated bond at the beginning of the period has, on average, a 0.35% chance of being downgraded to “D”, which typically means default.

Investors might have heard reports about how during the 2008 Financial Crisis, many “AAA” rated mortgage securities defaulted. However, before the defaults in 2008 and 2009, many of them were quickly downgraded by rating agencies in earlier years from “AAA”. Similar cases can be seen during the European Debt Crisis, when Greek sovereign rating were quickly downgraded from A1 in late 2009 to Caa1 by mid 2011 by Moody’s.

During the period of sharp downgrades, investors might see their originally “AAA”, “AA” or “A” rated bonds quickly losing both market values and liquidities. They might not be able to sell their holdings as there will be few if any buyers left in the market.

(Source: S&P Global Ratings Research and S&P Global Market Intelligence's CreditPro®)

Comparing Two Bonds with Different Ratings

In order to make a fair comparison between two bonds to better evaluate their respective credit risk, some variables (e.g business sectors, years left to maturity/next call date) have to be identical. From the table above, we can infer that the bond of Maybank is relatively more stable in fulfilling its debt obligations compared to that of Ambank. By investing in Ambank’s bond, investors are expected to have approximately 64 basis points higher (4.05 – 3.41) as risk premium than investing in Maybank’s bond.

How do They Manage Potential Conflicts of Interest

Rating agencies typically receive payment for their rating services from the issuer at the time the debt is issued and the periodic revaluation and credit reports on the issuer’s financial position. Nevertheless, the potential conflicts of interest arise as the existence of the issuer-pay revenue model may result in compliant evaluations that are detrimental in putting the investor’s interest in priority.

Several measures have been taken by rating agencies to mitigate this issue and increase transparency and market efficiency at the same time. These measures include, for instance, clear segregation of function between sales departments and the research team that conduct the credit analysis and provide the opinions of the ratings.

The board committees also have the responsibility of setting another level of defence by limiting the number of personnel involved in the process of issuing rating opinions. The role of the committee is to assess the analyst’s recommendation for a new rating or a rating’s change as well as to provide additional perspectives and review the standard of adherence to the agency’s rating criteria. More importantly, the internal policies and procedures must be clearly defined and established. In the United States, the agencies are held responsible for losses resulting from inaccurate and false ratings.

Credit Rating Is Not the Sole Criterion

The collapses of Enron in 2001 and Lehman Brothers in 2008 have raised doubts on the credibility and reliability of credit ratings. Furthermore, rating agencies such as Moody’s, S&P and Fitch have been criticized for their close relationships with large financial institutions which lead to conflicts of interest, since issuers typically pay the agencies for the service of providing ratings. They also failed to identify all of the risks that could impact a security's creditworthiness, particularly in regard to structured loans/ mortgages products such as Collateralized Debt/Loan Obligations (CDOs/ CLOs), many of which were rated AAA right before they suffered impairment. Credit rating may be treated as an important consideration for bond investing. However, it should not be the sole criterion as there are other important factors to be considered prior to making a bond investment.

It is important for investors to understand that the initial assigned bond rating may vary over time due to positive or negative future developments impacting the issuer. In addition, a bond investor should also consider investment strategy, time horizon, the composition of the investment portfolio, risk tolerance level and other relevant factors as crucial elements in evaluating a bond investment.

Disclaimer:

The information in these articles are for general information purposes only and is provided on an “as-is” basis without any representations or warranties of any kind. The information does not constitute legal, financial, trading or investment advice. You are advised to seek independent advice and/or consult relevant laws, regulations and rules prior to relying on or taking any action based on the information presented. In no event shall Bursa Malaysia Berhad and its subsidiaries and iFAST Capital Sdn Bhd be liable for any claim, howsoever arising, out of or in relation to do not accept any liability for the information provided in these articles, (including but not limited to any liability pertaining to the accuracy, completeness or currency of the information,) and for any investment or trading decisions made on the basis of the information.