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Why Credit Ratings Matter

  • Financial Analyst
  • Blog post submitted on 24th July 2019
06744 CC Trader Talk V2

On 19th July 2019, Moody’s upgraded Malta’s long-term issuer rating to A2 from A3, while concurrently moderating the outlook from positive to stable. The quoted key drivers for the upgrade included the improvement of Malta’s fiscal strength and fiscal policy framework as well as the country’s strong medium-term growth prospects. But why does this matter?

It is important to note that in the world of credit ratings market practitioners generally deem a company or country only as good as its worst credit rating or composite average. Currently Malta’s long term credit rating profile among the rating agencies includes an A2 from Moody’s (equivalent to “A”) with a stable outlook, A+ from Fitch with a positive outlook, A- from Standard & Poor’s with a positive outlook and AH (equivalent to “A+”) with a stable outlook from DBRS.

Rating agencies typically focus their analysis on four broad categories: Economic structure and performance, Government finances, External payments and debt, Susceptibility to events. The private sector is also typically included in the rating process in order for the rating agencies to get an independent view on government policies and strategies.

Credit ratings are significant as investors use credit ratings as a standardised yardstick for the risk associated with their investment decision making. Credit ratings provide an independent and objective assessment of the credit worthiness of countries and corporations. This assists investors to decide how risky it is to invest money in a certain country or corporation. As always, the higher the risk, the higher the expected return in order to compensate for the incremental risk. On this note, a country or corporation’s cost of funding varies according to the investor’s perception of the risk associated with a company.

This is applicable to both bonds and equities. The downward pressure on prices associated with equities in the case of a downgrade would typically originate from the higher discount rates used when determining the value of a firm; at least in theory. In the case of bonds, it is not as clear cut as yields vary according to either interest rates or the credit quality of an issuer, or a combination of both. For higher quality bonds (rated BBB- or above) the main driving force for yields are the benchmark interest rates, as the incremental change in default risk is insignificant. For lower quality bonds, credit ratings are more influential as the risk of default is high, and any movement in the ability of the corporation or country to repay its obligations will have an effect on the price/yields of the entity’s bonds.

As a general rule, for firms and governments who want to raise money in the capital markets, a favourable rating means a country will be able to obtain funds at a lower cost. This is fundamentally the most important inference from credit ratings. When it comes to the local market, few firms have a credit rating, possibly as a result of the cost involved or due to outcome of the analysis which the firm probably feels doesn’t add value due to its probable outcome. In fact, one of the main drawbacks with the credit rating system is that the issuer companies themselves need to pay credit rating agencies, often being not measly sums for complicated corporations.

Another dynamic is at play for companies or countries which get downgraded from a high quality credit rating to a speculative grade rating (BB+ and below). These are coined “fallen angels” and suffer from both the negative windfall from the downgrade as well as further downward pressure from the removal of the company or country’s bonds from managed funds, whose mandate is to hold bonds of a certain minimum credit quality. The opposite also holds true for entities who achieve an investment grade rating, called “rising stars”.

Lastly, credit ratings are often used as political tools, being used by governments as a measure of gauging their performance relative to peers.

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