Credit Ratings

Didn’t you feel proud when your teacher gave you an A+ at school? Or were you a C student, must try harder? Don’t tell us you were an F! My, you’ve done well…considering.

Just as teachers grade their students so there are businesses who grade investments. The three main credit rating agencies are Moody’s Investors Service, Standard & Poor’s and Fitch Ratings. Such agencies analyse the creditworthiness of companies, and their likelihood of going bust, as well as the risks in individual financial instruments. And they rate countries too.

Let’s take Moody’s for example. Their ratings start at the top, with the rating Aaa, “The highest quality and lowest credit risk” and “Best ability to repay short-term debt.” Below, and a smidgen riskier, comes Aa1, then Aa2, Aa3, followed by A1, A2 and A3. These are still supposedly low credit risk. We move even lower to the Bs with Baa1, Baa2, Baa3, then Ba1, and so on. All of these are higher risk with some “speculative elements.” By B1, B2 and B3 we are in high credit-risk territory. Finally come the Cs, the lowest of which is C itself “Rated as the lowest quality, usually in default and low likelihood of recovering principal or interest.”

Baa3 and above the instruments are supposedly “Investment grade.” Ba and below are non investment grade, also known as “junk.”

Good idea, no? And very helpful to investors. Knowing how professional bodies perceive risk in these companies and products can help investors make qualitative judgements about what to add to or subtract from their portfolios. But there’s more, there’s a quantitative angle to this as well. Let’s take as an example a bond rated Ba2. This bond has a price in the market. Suppose it yields 3% per annum. And suppose bank, i.e. risk-free, interest rates are 2%. Then (under lots of assumptions) these numbers can be interpreted as there being a 3-2=1% probability of the company defaulting on that bond in a year. (That’s 99% chance of getting one dollar and two cents back for your one-dollar investment, and 1% chance of nada.) Now we are in the realms of mathematics and can make quantitative judgements about whether Ba2 bonds are too risky, or which specific bonds to buy.

There are problems with this, or we wouldn’t be writing about this topic.

The first problem is the concept of quantifying probability of default. As a rule bankruptcy is a one-off event from which one doesn’t recover in the same form as before the bankruptcy. And as such a company only experiences this once. Therefore there’s not that much in the way of statistics for individual companies, only statistics about types of companies or companies with the same credit rating. There are parallels with health and death. Death is also a one-off event, at time of writing, and anyone who tells your life expectancy is basing that on tables of life expectancies of people with the same credit health rating as you, whether you smoke or not, take part in dangerous sports, etc. The mathematics of death and bankruptcy are very similar. More about life and death later.

But there’s a bigger problem. It concerns who pays for the credit rating. And it’s not who you’d expect. The credit rating on company XYZ is typically paid for by…company XYZ.

They need the rating to be taken as a serious investment, and they want it to be as high a rating as possible. The rating agency want their business and a happy customer. It doesn’t take a genius to figure out that their two interests are aligned. Had they been business partners then having perfectly aligned interests is exactly right. But here the rating agency is supposed to be acting as an unbiased middleman between the investor and the investment.

A third problem related to the above is that having competition among rating agencies might lead to companies choosing to work with those agencies that are the softest, who give the highest rating. None of this is helped by the lack of transparency about the rating process itself.

This is moral hazard.

Never mind all those problems. The main thing is that mathematics is involved. So it must be ok.