The role of credit ratings explained

Amid all the discussion about the role of credit ratings in financial markets, their actual performance has often been misunderstood. Ratings are forward looking opinions of relative creditworthiness, so their performance can be measured by how well correlated they are over time with defaults and by the rate at which they change.

The key test is whether ratings have, generally speaking, effectively rank ordered credit risks. In other words, have highly rated credits generally displayed lower default rates, and greater credit stability, than credits with lower ratings?

We have acknowledged that the recent performance of certain ratings in two specific areas,  US residential mortgage backed securities and related collateralised debt obligations, has been disappointing and we have taken major steps to address that. Elsewhere, however, ratings of companies, and most classes of structured securities have generally continued to perform well.

The latest studies of corporate defaults spell this out clearly. Between 2008 and 2010, spanning the worst economic downturn for decades, the global average default rate for companies rated investment grade was 0.9%, compared with 13.9% for those with speculative grade ratings. None of the 81 rated companies that defaulted in 2010 began the year at investment grade. At the same time, ratings stability increased, with the proportion of unchanged corporate ratings reaching 73%, a six year high.

Overall, the performance of global corporate ratings during 2010 was broadly in line with their strong historic track record. It follows the record 289 defaults among rated companies and financial institutions in 2009, 86% of which had a first (original) rating at least three notches below investment grade.
 
In short, there continues to be a strong correlation between corporate ratings and defaults and higher ratings have consistently demonstrated more stability than lower ratings. This is true for all corporate rating categories and geographic regions, an important point for investors who look to ratings to provide a common and comparable benchmark of credit risk across different sectors, regions and time.
 
The recent performance of certain ratings of structured securities has been more mixed. The extreme credit cycle and high unemployment, which has impacted loan repayment, have hurt the performance of many structured finance securities, especially those linked to US mortgages.

Elsewhere, though, the performance of structured finance ratings has been more in line with expectations. That includes, for instance, US securities backed by credit cards, student loans and other consumer debt, as well as most types of European structured instruments.

Despite the severity of the recession in Europe, default rates for European structured securities have been relatively modest, even among securities with low original ratings. And those securities with high investment grade ratings have been relatively stable in credit terms.
 
Over the three-year period since June 2007, European structured finance securities rated by S&P have experienced a cumulative default rate of below 1% (by value of original issuance) and a cumulative downgrade rate of under 20%. For consumer related securitisations, the cumulative default rate over this period is below 0.1% and the downgrade rate around 5%.

Despite the difficult economic situation in Europe and higher delinquencies and defaults in both corporate and consumer loans backing many structured securities, the cushioning against credit losses in these securities has meant their ratings have generally stood up well.

Importantly too, ratings in recent years have generally been much less volatile than market prices.
Ratings are based on fundamental analysis of credit quality, while bond and credit default swap prices are driven by the ebb and flow of market sentiment, the liquidity of a security (which can be limited) and other short term technical factors. That means credit markets are prone to regularly overshoot or undershoot, while ratings take a longer term view of credit risk and tend to follow a more stable path.

A high rating, of course, is not a guarantee an issuer or debt issue will not default over time. However, it remains the case, as the latest ratings performance data suggest, that higher ratings are generally less prone to default and tend to be more stable than lower ratings.
 
The analytical and other changes we have made over the last three years underline our commitment to continue doing so in the future. They are aimed at strengthening our ratings so they continue to be broadly comparable across all categories, clear and understandable, and perform as we expect.