Standard & Poor's or Moody’s credit ratings

Question

I have noted of late that much is being made of the risks of investing in these ‘non-bank’ finance companies after the failure of some. I have also read that any without a credit rating should not be worthy of investment and are likely to be very risky.

What I don’t understand is that there seems to be any number of ratings used and they seem to be somewhat in contradiction of one another. We are more confused than ever.

Answer

In New Zealand Standard & Poor's or Moody’s credit ratings are the most commonly known, but even so, unlikely to be well understood. In the wider Australasian market Rapid Ratings, PIR (Property Investment Research), Morningstar, Fundsource, Lonsec and Fitch among others, are all useful in providing research ratings when assessing investment assets.

In NZ a further number, numerically or alphabetically, try to score quality on little more than educated guess work. By this I mean no face to face interview activity and/or deeper study has been undertaken, the score is at best a superficial assessment of publicly available data – hardly robust enough to meet the criteria of fiduciary prudence when considering an investment of your current wealth and future fortune.

A rating is an opinion of creditworthiness with respect to a specific financial obligation, class of financial obligations, or a specific financial program (including medium-term fixed interest notes and commercial paper). It also considers the creditworthiness of the guarantors, insurers and the currency denominated, if appropriate.

It is important to understand that a credit rating is not a recommendation to purchase, sell, or hold a financial instrument or investment, in that it does not comment as to market price, rate of return or suitability for a particular investor.

What a rating tries to convey, in an impartial way, is the principle that potential returns rise with an increase in risk. In other words, money can produce higher profits only if subject to the possibility of loss. Readers of my articles will know that I do not totally agree with this hypothesis as there have been (and are currently) investments of extreme risk, yet promoted returns/rewards were/are no more than average for the class of asset – the trick is to identify which is which.

Taking on some risk is the price of achieving acceptable returns, you can't cut out all risk. The goal is finding a balance – one that generates profit, but still allows you to pass the sleep at night test.

A rating helps for sure but make sure you really understand which is ‘investment grade’ and which ratings or scores just sound good. Go for those that have a current, published investment grade rating or if you must, ask the others why they are not rated before taking the plunge.

Original Article published August 2006