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Credit Ratings: Decoded

SO WHAT ARE THEY? In a nutshell, a credit rating is an independent opinion of the financial strength of a company, and more importantly, its ability to repay its debts in full and on time.

WHO ISSUES THEM? They are issued by independent credit agencies, the most internationally recognized being Standard & Poor’s, Fitch Ratings, and Moody’s Investors Services.

HOW ARE THEY CALCULATED? The rating agency looks at a wide range of financial measures when assessing an entity’s financial strength, as well as assessing the external environment the entity operates in, along with qualitative measures such as quality of management and internal processes.

HOW IS THE RATING EXPRESSED? The most common manner is in the form of an alphabetical rating, with a higher rating being superior to a lower rating. For example ‘AA’ superior to a lower rating ‘C’. A higher rating is better, indicating a lower chance of default than a lower rating which has a higher chance of default.

WHAT DOES THE RATING MEASURE? The usual assessment is likelihood of the entity to not meet a payment of either interest or principal in the next 5 years.

IN WHAT WAY ARE THEY USEFUL? Credit ratings allow an investor to get an independent assessment of the risk of a possible investment. This allows the investor to assess whether the return is appropriate for the level of risk they are taking as well as whether the risk of the investment is appropriate for their particular risk profile. They also allow comparison of relative risk of entities that operate in different industries, sectors, and geographic locations.

WHAT DON’T THEY DO? Credit ratings do not guarantee that the entity will be financially sound in the future. Even an ‘AAA’ rated bank has a 1 in 600 chance of defaulting in the future. For example Greek government debt initially had a credit rating of ‘A’ back in 2009.

IF AN ENTITY IS UNRATED, DOES THAT MEAN THEY ARE HIGH RISK? Not at all. Quite often entities, due to the low risk nature and financial strength of their business, can ironically issue debt without the need for a credit rating. Getting a rating from one of the major credit agencies can be quite expensive and for that reason some entities decide to forgo getting a formal credit rating.

WHAT IS MEANT BY ‘MINIMUM INVESTMENT GRADE’? This was initially introduced when US regulators imposed a minimum credit quality on investments held by regulated institutions for security. This has now been adopted by the broader investment industry to denote minimum creditworthiness. This rating is a +/- ‘BBB’ rating or as seen in the scale, this implies 1 in 30 chance of default.

AN IMPORTANT NOTE REGARDING RATINGS: When it comes to the credit rating, more is better. So a credit rating of ‘AA-‘is better than an ‘A+’. Similarly, a minimum investment grade of ‘BBB-‘is higher than a non- investment grade of ‘BB+’.

CONCLUSION
Credit ratings are a useful and essential guide when assessing the risk of default from an entity. However, they are only just that, a guide. A high credit rating does not guarantee return Of interest and principal, likewise the lack of rating or a low rating does not mean that a loss on an investment is likely to occur.

Every investment, regardless of credit rating or lack thereof, must be assessed by the investor and their advisor as to the appropriateness for their portfolios. Ultimately, it is the underlying financial performance of the issuing entity that will determine the investment outcome, and that is why proactive monitoring of one’s investments, in partnership with your advisor, is the best way to maximise returns and reduce risk, to achieve your investment outcomes.

 

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