LO 19.4: Describe rating agencies assignment methodologies for issue and issuer ratings.
Rating agencies have a goal of running systematic surveys on all default risk determinants. In their approach, both judgmental and model-based analyses are integrated. Whereas a small component of revenues for rating agencies comes from selling information to market participants and investors, the vast majority of their revenues comes from counterparty fees. Because rating agencies are concerned with maintaining their reputations, and because the issuers who pay the rating agencies to rate them want to demonstrate the credit quality of their issues, the investment community (investors, buyers, and traders) can rely on the work of these agencies.
An agency will have potential access to privileged information, as they have a window into managements strategies and vision. To successfully assign a rating, an agency must have access to objective, independent, and sufficient insider information. As an example of the decision-making process for assigning a rating, Standard & Poors has an eight- step process beginning with receiving a ratings request from an issuer and followed by the initial evaluation, meeting with management, analysis, a review and vote by the rating committee, a notification to the issuer, the dissemination/publication of ratings opinions, and continued monitoring of issuers and issues.
The final rating for a corporate borrower will come from two analytical areas: financial risks (accounting, cash flow, capital structure, etc.) and business risks (industry analysis, peer comparisons, company positioning relative to peers, country risk, etc.). As an example, in
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Topic 19 Cross Reference to GARP Assigned Reading – De Laurentis et al., Chapter 3
assessing financial risks, Standard & Poors focuses on coverage ratios, liquidity ratios, and profitability ratios. Higher margins equate to a safer financial structure and a higher credit rating for the borrower. This analysis is then merged with assessments of sovereign risk, the competitive environment of the issuer, and the strength of the business sector.
Along with the factors noted previously, additional analytical areas include firm strategy coherence and consistency, managements reputation and experience, profit and cash-flow^ diversity, the ability of an organization to address competitive needs, and the organizations resilience to business uncertainty and volatility. The quality of a firms internal governance; exposures to legal, political, environmental, and institutional risks; technological sustainability; and potential liabilities tied to employees are all relatively new factors addressed in ratings analyses. It is worth noting that an entity can have favorable positions in some of these analytical areas and less-favorable positions in other areas without it negatively affecting ratings.
At this point, there are only three main international ratings agencies: Moodys, Standard & Poors (S&P), and Fitch. Moodys focuses more on ratings for actual issuances themselves, as opposed to ratings for issuers. S&P focuses on ratings for issuers. Fitch provides issuer ratings based on potential defaults for publicly listed bonds (which ignore commercial and private bank borrowings). The obvious challenge is the lack of comparability among the agencies, although recent market pressures have led to agencies using more quantitative analyses that facilitate easier comparisons.
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