Richard Hunter explains ... Ratings

Credit ratings are an opinion on the ability of an entity or of a securities issue to meet its financial obligations or commitments on a timely basis. Credit ratings are not recommendations to buy, sell or hold a security. They are not audits, assessments of the possibility of fraud, or second guesses of events yet to take place. Neither are they commentaries on the pricing of bonds relative to ratings or an expression of a percentage probability of default.

The three dominant rating agencies, Fitch Ratings, Moody's Investors Service and Standard & Poor's, assign ratings to corporates, sovereigns (countries), local authorities, financial institutions, debt issues made by or loans to each of the above, tranches of structured transactions, or a legally 'ring-fenced' entity set up for the sole purpose of issuing debt to finance a portfolio of assets - for example, mortgage loans or trade receivables.

For Fitch and Standard & Poor's, the ratings most commonly quoted - long-term senior, unsecured issuer counterparty ratings - run from AAA to D, with AAA being the highest rating. The suffix '+' or '-' is added to denote relative status within major rating categories. Moody's scale runs from Aaa to C for long-term ratings. Moody's uses numbers rather than +/- modifiers to denote relative status within major rating categories.

Markets have traditionally viewed ratings at or above BBB-/Baa3 as 'investment grade'; ratings below this level are considered 'speculative grade', colloquially known as 'high yield' or 'junk'. Investment guidelines and indices often limit investment in instruments rated in the speculative grade. Ratings also carry an outlook and can carry a 'rating watch' to reduce 'bolt from the blue' rating actions and highlight concerns. An outlook may be positive, stable or negative and indicates the most likely direction of a rating over a one- to two-year period. A positive rating watch indicates a potential upgrade, negative indicates a potential downgrade, while an evolving rating watch may be raised, lowered or maintained.

Ratings are arrived at after an analyst reviews information which is either publicly available or provided on a confidential basis. After a rating review meeting, a draft report is prepared and a rating committee held, then a report and rating action commentary in the form of a press release is published. There is ongoing surveillance of all credit ratings and reviews can be event-driven or period-driven - ratings are formally reviewed at least once annually.

What consumers typically want from the rating process varies. The issuer wants an experienced lead analyst, transparent criteria for their sector, an intelligent rating committee, a dialogue on rating findings and a high rating. At the same time, it also wants to avoid rating volatility, and downgrades in particular.

The bookrunner wants all these things but wants absolutely the highest possible rating to be assigned initially while being arguably less concerned about volatility and future downgrades.

The investor wants the experienced lead analyst, transparent criteria and intelligent rating committee, but some may want low ratings, which would force a higher coupon from the issuer. Conversely, some may want a higher rating than might be appropriate, which would let them hold a higher-yielding instrument.

GLOSSARY

Investment grade: Ratings at or above BBB- as rated by Standard & Poor's or Fitch, or Baa3 by Moody's

Speculative grade: Also called junk or high yield; ratings below BBB-/Baa3, for which investment guidelines and indices might limit investment

Outlook: An indication of the likely direction of a rating over a one- to two-year period

Rating watch: An indication of a heightened probability that a rating change will take place, a positive rating watch indicating a potential upgrade and a negative rating watch indicating a potential downgrade.