The fixed income market (and fixed income securities) is one of the most popular asset class within global capital markets, after the currency markets. Its versatility and characteristics make them more appealing to the retail investor more than for the institutional investor as the notion behind a fixed periodical payment makes retail investors automatically attracted to this asset class. Furthermore, it has, well historically, been one of the more defensive asset classes from a risk perspective, also given the recent wave of quantitative easing by the world’s leading central banks.
But do investors really appreciate the underlying risks of a fixed income investment?
Amongst a number of analytical tools research analysts, asset managers, portfolio managers, as well as investment advisors use to assess the risks inherent with a bond investment are credit ratings. By definition, a credit rating is an mathematical and analytical valuation model, used by credit rating agencies, which assigns what is known as a credit score which encapsulates the credit risk of a bond issuer, predicting the ability of the issuer to pay back the debt, as well as assign a forecast, by means of a scoring system, of the likelihood of the debtor (bond issuer) defaulting.
A credit rating agency is a company which is assigned with computing and assigning such credit ratings. It is customary for a bond issuer to contact credit rating agencies to assign a credit score/rating to its outstanding bonds (naturally at a fee), in order for investors to be more aware of the risks involved when purchasing their bonds.
Credit rating agencies carry out periodical reviews of the underlying operations of the company which it is tasked to perform a credit analytical review of. This review consists primarily of analysing the company’s operations and financial situation, meetings with top management, as well as through, industry, sector, and country review upon which to base their forward-looking statements, assumptions and outlooks.
Prior to being made public, senior officials from such credit ratings meet up with the company’s management team so as to discuss and review the various assessments, assumptions and calculations upon which the final credit scoring/rating is based in order for the credit ratings to be credible to the investor population, one must appreciate that despite the fee charged by the agencies themselves, the final outcome and rating is a totally independent on.
Apart from the headlines, it is important for analysts and investors to thoroughly read through and scrutinise. For instance, the basics of the report would include text such as “Credit rating agency ABC has today downgraded the long-term issuer and senior unsecured debt ratings of company XYZ to AA from AA+. The outlook has been changed to stable from negative.”
That’s the very high-level statement which makes the headlines. However, what investors need to watch out for are the subsequent segments within the report (or official statement), which may vary from one rating agency to another:
• The key drivers for the upgrade/downgrade
• Ratings Rationale
• Rationale for altering the outlook on the Rating
• What could move the rating up/down
• Importantly, an estimated ‘recovery rate’ in the case of default
Bond prices move up and down, depending on the prevailing market conditions, sentiment, interest rate scenario. Most importantly, bond prices move because there are underlying risks in holding that security. The credit rating agency’s reports hold vital information which could explain some vital information and explain some bond price movements
If markets are clearly indicating that a credit rating of a bond issuer could come under pressure (as per details provided in the “what could move the rating up/down section”), then this could clearly be the cause behind certain price movements. Bond prices move up and down for a reason, and credit risk is one of the major contributors for this – investors need to meticulously look out for and be aware of such risks, and credit ratings seek to do just that.
This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.