Rating Agencies Demystified — Part II

In our last article, we looked at what is a credit rating. This second article will examine how bonds and issuers are rated and how rating agencies take into account ever changing circumstances which may be general or specific to the issuer.

Rating agencies base their “rating” decisions on extensive analysis of the issuer’s financial condition, operating performance, policies and risk management strategies. By this analysis they try and evaluate revenue sources available to the issuer to cover debt service. Apart from current and historic information,rating agencies also evaluate the potential impact of forseeable future events while arriving at their “rating” decision.

The following factors are generally kept in mind by rating agencies whileassessing the credit worthiness of an issuer:

a) financial and business attributes that may influence the issuer’sability to repay; b) issuer’s financial condition; c) economic, regulatory and geopoliticalinfluences; d) quality of management; e) competitive position of issuer in its industry.

Whilerating governments, the analysis may concentrate on political situation and risk, monetary stability and the country’s debt position.

Whilerating an individual bond issue, an agency will review the creditworthiness of the issuer, as well as evaluate the specific terms and conditions of the debt security includingits position with regard to other debt obligations of the issuer, as well as other external credit supports such as guarantees, insurance and collateral.

Forecasting future financial and economic conditions can be tricky, particularly if it is for a longer period — the further the agency predicts into the future, the more imprecise and unreliable their forecasts become. To keep their ratings current, agencies typically track changing conditions that may affect the creditworthiness of an issuer or a debt issue, particularly changes that could hurt earnings or revenues or issuer performance. This could include shifts in the economy, credit markets or business environment, or changes in more specific circumstances affecting a particular industry, issuer or an individual issue. For example, if a company buys another company with lots of debt, the amount of outstanding debt owed by an issuer may increase sharply virtually overnight.

If a rating is under review, agencies will signal this possibility by placing the issue or issuer on a “watchlist”. Moody’s call this a “watchlist”; S&P calls it “creditwatch” and Fitch calls it “Rating Watch”. Remember, this onlymeans that a change in rating is “possible” — not inevitable. Also remember, that a“watchlist” entry may mean either a possible upgrade or a downgrade. Also remember that a rating change can happen “immediately” without an issuer going on a watchlist. Ofcourse, once a rating has been reviewed and either changed or affirmed (i.e. no changeto current rating), it is removed from the watchlist.

A rating change can have an impact on the price of an issue. The change in price corresponds to the amount necessary to bring the current yield of the bond in line with other bonds rated at the same, new level. Certain ratings changes affect prices more than others. For example, a highly rated bond that is downgraded one notch may produce litlle noticeable difference in price. However, certain downgrades are more significant than others and should be viewed as red flags including:

a) a down grade that drops a rating to below investment grade; b) a downgrade of more than one rating notch — eg. from AA to BBB; c) a string of downgrades in close succession.

The next and finalarticle will examinerating scales and what ratings do and don’t reveal.

Views expressed by the author are his own and do not reflect the newspaper’s policy.

More news from Business