The ongoing debt crisis in Europe has focused more attention than ever on credit ratings, but a key question that is often overlooked is whether credit ratings actually do the job they are designed for
The track record of our corporate ratings as indicators of default risk is very strong and has remained so during the financial crisis. But before examining this track record in detail, it is important to state what a credit rating actually is, and just as importantly, what it is not.
A credit rating is an opinion about relative credit risk, ie the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest, within a universe of credit risk. It is not a guarantee of credit quality or an exact measure of the probability that a particular issuer or particular debt issue will default.
For example, a corporate bond rated ‘AA’ is viewed as having a higher credit quality than a corporate bond with an ‘A’ rating. The ‘AA’ rating is not a guarantee that it will not default, but rather that it is less likely to default than the ‘A’-rated bond.
The performance of ratings can be measured objectively by how well they correlate over time with defaults, and by their stability (the rate at which they change). Our studies consistently demonstrate a clear correlation between ratings and defaults (the higher the issuer rating, the lower the observed frequency of default, and vice versa), and that ratings are progressively more stable as you ascend the ratings scale.
In Standard & Poor’s long-term rating scale, issuers and debt issues that receive a rating of ‘BBB–’ or above are generally considered by regulators and market participants to be “investment grade,” while those that receive a rating lower than ‘BBB–’ are generally considered to be “speculative grade”. Between 1981 and 2011, the average five-year default rate for investment grade corporate issuers was 1.17 percent, compared with 16.82 percent for speculative grade companies. In Europe over the same period, the average 5-year default rate for investment grade corporate issuers has been 0.5 percent, compared with 11.15 percent for speculative grade companies.
We publish in-depth annual default studies covering a range of asset classes and regions, and make these studies available to market participants and regulators. On a global and European basis, the performance of our corporate ratings during 2011 remained broadly in line with their strong historic track record. Ratings continued to serve as effective indicators of relative credit risk over time, with a clear correlation between ratings and defaults. This was true for all rating categories and geographic regions.
In line with all our previous default studies, the 2011 study showed that entities with higher ratings default less frequently than those with lower ratings, higher ratings are more stable than lower ratings and speculative-grade ratings generally experience more volatility. This applied across all regions.
The Gini ratio – a key measure of the relative ability of ratings to differentiate risk – was at its sixth-highest level since our default studies began in 1981. This demonstrates that the ability of corporate ratings to serve as an effective measure of relative risk remains intact.
Looking specifically at Europe, ratings also continued to serve as effective indicators of relative credit risk in 2011, with a clear negative correlation between ratings and defaults.
Despite increased uncertainty among European sovereigns, only four rated corporate issuers in Europe defaulted in 2011, affecting debt worth $5bn. By contrast, corporate defaults totaled three in 2010 ($9.3bn in debt) and 20 in 2009 ($39.7bn in debt). No investment-grade-rated entities defaulted in 2011. All four European defaulters in 2011 were nonfinancial companies, with all four defaulters initially rated ‘BB+’ or lower, and rated CCC or CC prior to default. The average time to default from first rating for the four defaulting issuers in 2011 was 5.4 years.
Expressed as a percentage of the rated universe, the speculative-grade corporate default rate in Europe ended 2011 at 1.60 percent, up from 1.01 percent in 2010, but still much lower than 8.08 percent at the end of 2009. By contrast, speculative-grade corporate default rates in 2011 were 1.71 percent globally, 1.98 percent in the US, and 0.59 percent in the emerging markets. When including all rated entities, Europe recorded a default rate of 0.34 percent at year-end 2011, compared with 0.18 percent at the end of 2010.
Higher-rated companies took longer, on average, to default than did lower-rated companies, while stability rates (the proportion of unchanged ratings) were higher for companies with investment-grade ratings (‘BBB-’ and higher) than they were for companies rated speculative grade (‘BB+’ and lower). Just over 80 percent of European issuers rated ‘A’ at the beginning of 2011 were still rated ‘A’ at the end of the year, whereas the comparable measure for issuers rated ‘B’ stood at 64 percent.
Although the rating distribution in Europe remains solidly in investment-grade territory, the share of investment-grade entities continued to decline in 2011. Issuers rated ‘BBB-’ or higher accounted for 73.6 percent of all ratings at the end of 2011, compared with about 78.5 percent in 2010 and as high as 84 percent in 2008.
In summary, in 2011 corporate ratings continued to perform in line with their strong historic track record. Higher rated companies had greater credit stability, lower default rates, and they took longer to default than lower rated companies.
It is important to remember that a high rating is not a guarantee that an issuer or debt issue will never default, or that the rating won’t change suddenly. Creditworthiness can and does change, sometimes as a result of unexpected and unpredictable events. Investors expect a very strong record of indicating default risk, which is what Standard & Poor’s aims for.