Understanding Ratings and Risk

Fitch, Moody’s and Standard & Poor’s broadly interpret their ratings and key categories in similar fashion as ‘the current qualitative and quantitative assessment of an entity’s willingness and capacity to meet its financial commitments in full and on time’. 

In these key categories there is capacity to further subset each of them with the addition of a plus (+) or minus (-) to show relative standings within the major rating category. These ratings are an estimate of the probability of default, or failure to meet obligations, over a 12 month period.

For example; Out of every 100 ‘BB’ rated entities, on average less than two of them are likely to default in a 12 month period. On the other hand for those rated CCC, CC and C the range of default potential sky-rockets to 25.00% to 30.00%, or nearly one in every three, in any 12 month period.

For your protection as an investor, does this then suggest that all un-rated investment or just below the line BB’s (+/-) are the great unwashed of the investment world and should be avoided at all costs? Some of those with a superior rating may take the stance that this is so, however New Zealand to an extent struggles to have organisations of the size and therefore debt instruments in the local market that can carry the suggested international minimum ‘investment grade’ (BBB) laurel.

Over the last 12 or 24 months much has been made of the benefit of having a rating from one of the big three rating agencies. S&P is likely to be the most well known of the nomenclature in this part of the world. That said, the three equally are the yardstick or benchmark to consider above all other.

Of the top five core categories, taking in AAA to BB, the potential defaults are mildly increased at each step of the scale. For example AAA, 0.00% to 0.01%, BBB suggests a 0.20% to 0.40% default with BB at 0.60% to 1.60% - an appreciable stepping but nowhere near the depth of despair a C rated asset might deliver. There is not a linear curve of potential loss here - more a step over the abyss at point B and beyond.

It is highly unlikely any New Zealand domiciled financial product provider, without significant offshore financial linkage will deliver better that BB or equivalent – we are just not that big. Hats off to those that have stepped up and exposed themselves to the scrutiny required to achieve a meaningful rating – many are clustered at the acceptable BB+ - and the more the better.

A conundrum for investors in New Zealand has been that with very high interest rates (as measured by our OCR) most ‘investment grade’ assets have not delivered their (the investors) desired return. We have seen the fall out of some of those assets that promised the returns however these appear to have understated (or disguised) the risk.

Many would argue there is a place in portfolios for both investment grade and non-rated debt assets. The answer can only lie with the investor. Either way, if the risks can be adequately assessed and the pricing spread reflects the risk it may be no problem - but be warned, a rating is there good or bad for a reason, not that it cannot change! Positively, we are now starting to see a more balanced understanding of risk and returns – and a rating certainly helps in this assessment - long may that improve.

Original Article published February 2008