Credit Rating Score – How does it work?

An Overview of Credit Ratings

Debt instruments are dated to have their origins as far as 2400 years BC back in Mesopotamia; the ancient country was the pioneer of setting, so-to-say, a capital market laws and rules. This specified bond provided safety for the payments of grains, if the transaction had not been done, the owner could have gotten reimbursement.
Several types of debentures were also emitted by Venetia to fund its war spending. The very first government bond (municipal in this particular case) was issued exactly 500 years ago by the City of Amsterdam in 1517, whereas, the premier National Treasury Bond was implemented by the Bank of England in 1693 to collect means to finance the conflict against France. The USA was no different; the country has been issuing bonds since the Revolutionary War, while the US Treasure Bonds (then named as Liberty Bonds) were initialized a century ago.

The new types of financial instruments did gain a huge recognition all around the world at the beginning of the 20th century, simultaneously; the investors started trying to estimate the risk and volatility of such assets. Three new companies, Fitch Publishing Company founded in 1913, Moody’s Investors Service set in 1909 and Standard & Poor’s Financial Services founded in 1960 (merged with Poor’s in 1941) took advantage of these shareholders concerns by publishing the creditworthiness ratings. Gradually, the evaluations of these private entities started to be seen as the benchmark whether the governments or firms are reliable to meet its debt obligations. After the creation of the Securities and Exchange Commission in 1936, a regulation was implemented to urge US banks to hold only “investment grade” rated debt instruments (based on the Agencies’ score). At the moment, “The Big Three” accounts for 95% of the credit rating business and have Nationally Recognized Statistical Rating Organizations Status.
In simple words, a credit rating is an evaluation of the likelihood of the debtor defaulting and the probability of paying back the debt. There are several factors being taken into consideration while determining the assessment including: Cash Flows, Central Banks decisions, Sector Specifics, Financial Strength, Default History, Government’s Fiscal Policy, Foreign Investment’s, Country’s Economic Status and others.

The Ratings are typically published thrice in a year by each company for a given institution; however, it is possible for the raters to restrain from publishing the new score and keeping it unchanged. The higher the rating (AAA/Aaa) the less riskily investing in the given asset is and the obligator has to pay a smaller amount of interest as a yield. As an effect, the debt serving requires smaller money resources. The lower the rating, the more hazardous debt instruments become from the investor’s perspective. On the other hand, they start to provide higher rates of return what might attract some of the buyers. However, we should keep in mind that a number of the investments funds are forbidden to put their money in lower graded bonds.

Table

Consequences of Downgrade – Polish and Turkish Examples

Here comes a natural question, what does the credit rating lowering really mean to a specific country. As a national bond goes a step closer to junk level, investors are less likely to purchase such an asset. In effect, the government has trouble with funding its debt in a long-term.

We could witness such a decision in regard to Polish Government Bonds in January 2016, when S&P Global Ratings released a statement of, for the first time in history, bringing down the rating from A- (positive outlook) to BBB+ (negative outlook) due to fiscal policy concerns. Right now, the Polish Treasury Bonds are rated: BBB+ (stable) [might be seen in Bloomberg as A-] by S&P, A2 (negative) by Moody’s and A- (stable) by Fitch. Immediately after the news came out, PLN tumbled to 4-year-low against EUR, 13-year-low versus USD, and weakened to CHF hitting a 12-month-low. Yield return rates went up significantly exceeding the 3% level. In addition, 13 billion dollars sell-off of the Polish bonds was observed (4 billion in the USA). We should not forget about the reputation loss, Poland was pushed towards the group of uncertain countries like Portugal, Greece or Spain. Regardless the fact that the state’s GDP rose more than 3% in 2015.

Bloomberg

Yet another prime example of the country suffering violently after the rating declining is Turkey. Turkish assets dived the most since a failed military coup in July 2016 and credit risk climbed after Moody’s Investors Service lowered the country’s sovereign rating to the junk level. Markets immediately reacted to the announcement in a negative way leaving the Turkish Lira hitting a 3-year-low to USD (the currency has lost 40% since 2013 when the US cut down on the cash flows to its emerging market). The yield on Turkey’s 10-year debt surged 28 basis points, the most among emerging countries companions. After the second downgrade in early 2017, TRY weakened, even more, nearly reaching the level of rate 4.0 to USD (which would’ve been a remarkable event). The inflation forecast has risen to 8% for 2017.

Lira

Undoubtedly, Credit Rating Agencies are crucial to the whole financial industry. every investment bank operates on the high volatility market that credibility was shaken violently by the recent fines for Deutsche Bank and Credit Suisse. To avoid such a threat, the investment companies minimize risk by analyzing the ratings issued by Mood’s, Fitch or S&P. The Bond’s classification might be easily found in either Bloomberg or Reuters terminals.

Leave a reply:

Your email address will not be published.

Site Footer