'Buyers beware' — credit ratings still matter
The Sterling Report
The credit rating agencies received severe criticism and in some instances blame for the financial crisis that peaked in 2008. The agencies assigned high credit ratings to mortgage backed debt securities and other derivative instruments which eventually became worthless at the height of the liquidity and credit crisis. This caused severe losses to investors and even resulted in insolvency for prominent institutions, some of which were rescued by the US Government. However, recent events in Greece, Belize, Grenada and Jamaica are timely reminders that credit ratings still matter. All of these sovereign nations were rated at the lowest level on the ratings scale of the major rating agencies prior to their credit events. The credit rating agencies may have performed poorly with respect to assessing complex financial instruments, but their analysis of credit quality still has some weight.
Greece executed in 2012 the largest debt restructuring in order to secure ongoing financial support from international creditors. Belize is on the verge of its second debt restructuring within five years after missing a coupon payment in August 2012 and then making a partial payment a month later. Grenada missed a September coupon payment last year and subsequently paid investors within a 30-day grace period, but recently declared its inability to continue to meet its current debt obligations and intent to restructure its public debt. In February 2013, Jamaica concluded the second restructuring of its local debt within three years and may execute a "market friendly" transaction on its external debt.
A credit rating indicates a borrower's ability to repay its debt in full and in a timely manner, and the rating assigned by a rating agency gives an indication of the risk of default of the issuer. Debt instruments are rated as investment grade securities or non-investment grade securities. Investment grade securities or high credit quality instruments are assigned rating scores ranging from AAA to BBB- by S&P and Aaa to Baa3 by Moody's. These securities are deemed to carry relatively low risks of default in the opinion of the rating agencies. Non-investment grade bonds pose significant risk of default and have scores ranging from BB+ to D by S&P and Ba1 to C by Moody's. Non-investment grade bonds are also referred to as "junk bonds" on account of the default risks they bear.
In recent times political risks have become an increasingly important consideration when ratings are being assigned, and therefore sovereigns with relatively low debt levels but significant political risk will receive low credit scores. Thus oil-rich Venezuela, for instance, has been viewed by the rating agencies as having significant political risk and therefore its sovereign bonds are rated at "B+" by S&P, thereby categorising them as junk.
Investors are being encouraged to obtain the ratings assigned on the instruments they invest in as this will give an indication of the level of risks (default & price, for instance) and whether or not they are being adequately compensated. Generally speaking, relatively higher returns can mean relatively higher risks, so investors, beware of the "junk" you include in your investment diet.
Eugene Stanley is the Vice President of Securities and Foreign Exchange Trading at Sterling Asset Management. Sterling provides advisory and financial services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org.