“One can predict the market trend as one can predict which way a bird will fly, when it leaves the tree.” Predictions about the future economic environment, as Warren Buffet makes clear, are best taken with a pinch of salt.
In spite of this, credit ratings – forecasts of a business or specific security’s creditworthiness – are a long-standing feature of modern financial marketplaces, widely used by both traditional and alternative finance providers.
But why do many financial institutions rely on credit ratings to help them make lending decisions?
Firstly, users of credit ratings benefit from the simplicity in interpreting ratings according to a widely used and understood rating grade system. Thus the credit opinions issued by rating agencies can easily be used by the buy-side industry when constructing and rebalancing portfolios according to the investment grade or high yield mandate given by investors.
Secondly, the detailed credit assessments provided by rating agencies explore various company and sector-specific factors and statistics which allow for comparability of ratings across geographies. Using the same standardised methodologies and financial statement adjustment policies across industries and geographies allows for objective assessment of a borrower’s ability to meet its debt obligations as they come due.
Thirdly, credit analysts usually monitor a portfolio of companies in the same sector which allows for comparisons of the performance of a specific issuer vs the issuer’s peer group. As a consequence, the cost of borrowing (i.e. interest rate) can be calibrated according to the Borrower-specific credit risk.
But credit ratings are not without their limitations.
Credit ratings could in certain instances not always be up-to-date as the performance of the business can change significantly month-to-month, for instance when a major contracted revenue source is lost. The methodology for issuing a specific rating might be slow to adapt in response to regulation, changing accounting practices and other criteria such as environmental, social and governance factors.
Credit ratings rely on audited financial statements. A conflict of interest between the auditing and consulting part of the business have been scrutinised by the Financial Reporting Council (FRC), the UK accounting regulator, calling for ring-fencing of the Big 4’s audit business by 2024 in response to corporate failures as in the case of Carillion. On 28 August 2020 the FRC delivered its Initial Investigation Report (IIR) in connection with its extensive investigation into KPMG’s audit of the financial statements of Carillion plc with no final determination being made yet. A thorough review of all findings and assumptions of the auditor could potentially highlight issues ahead of a final credit rating but due to time constraints such a thorough review is not always possible.
Another possible limitation relates to the commercial nature of the borrowing / lending process too. The Lender’s own interests (generating revenues through interest margins and fees) might lead to lowering of credit standards in the pursuit of extending a funding line at favourable terms for the Borrower.
The main revenue source of credit rating agencies is derived from the issuers whose securities they rate. The business model of rating agencies has adapted in the past years to include a greater reliance on other business segments such as technology and related services but a comparison of S&P’s 1H 2015 revenues with the 1H 2020 revenues by product segment as per recent investor presentations shows that close to 50% of revenue is still generated by the ratings part of the business with over 50% of the operating profit generated in the ratings line of business.
Last but not least, forward looking credit opinions employ a mix of historical data and forecasts in the credit analysis process but past financial performance is no guarantee for future accomplishments, as often buried in disclaimers to financial reports and presentations. A well-established recurring revenue business model might not continue in the future if its customers do not receive the same level of high quality service they signed up to in the first place.
Peter L. Bernstein refers to the word “risk” deriving from the early Italian risicare, which means “to dare” and argues that risk is a choice. Thus, as well as considering the pros and cons of credit ratings, any institutional or retail investor must of course also consider their own mandate, risk preferences, investment horizon and other factors before reaching an investment decision.