investment viewpoints
Swiss bonds: how important are credit ratings?
Credit ratings are an important indicator for bond investors, for many reasons. However, they are just one piece of the puzzle. In this report, we outline how ratings are derived and their purpose. We also explain why investors should not rely solely on this measure when making investment decisions.
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What the ratings show
Credit ratings serve as a reference for bond valuations and are an important risk measure. For a start, the permissible investment universe for a portfolio is often defined by rating specifications.
What is the rating? Simply put, it is a standardised assessment of a bond issuer’s creditworthiness and indicates the likelihood that the issuer will meet its debt obligations. Creditworthiness includes both the ability and the willingness of the issuer to meet its full debt obligations immediately and at any time.
Ratings apply to both issuers and individual debt instruments (mainly bonds). In general, the weaker the rating, the higher the interest cost for the debtor. Ratings are forward-looking and aimed at being stable through the economic cycle. Frequent rating adjustments can lead to undesirable market volatility and reflect poorly on rating agencies. Temporary and cyclical influences should therefore have no effect on the rating, at least in theory.
Ratings in Switzerland
Rating agencies are mostly private and independent companies. Unlike in most markets, ratings in Switzerland are not dominated by the big three providers: S&P, Moody's and Fitch. Almost 60% of domestic issuers in the Swiss Bond Index do not possess a rating from one of those three agencies. Reasons for this can include the small size of issuers or the agencies’ general lack of expertise about the quirks of the Swiss market.
Therefore, some Swiss banks (currently ZKB and UBS1); the corresponding Credit Suisse service has been discontinued) and domestic rating agencies (Fedafin, I-CV1) act as rating providers in the market.
Abrupt changes to ratings can lead to strong price reactions in the bond market. For that reason, agencies tend to signal them in advance by issuing negative or positive outlooks. Such outlooks remain in place for an average of one to two years. However, agencies can also place the rating on a watchlist to assess certain events and short-term developments and, if necessary, change the rating within a shorter period.
Swissair shows there are no guarantees against default
It is important to emphasise that a credit rating represents an opinion about credit quality and is not a trade recommendation. It is based on quantitative and qualitative analysis of both historical and current information. Rating agencies may arrive at more objective and better-supported assessments of credit quality than the average market participant due to their expertise, but they can still be vulnerable to fraud or unforeseen market developments.
Hence, even the strongest ratings should not be seen as a guarantee that the issuer will meet its interest and principal obligations. One good example in Switzerland was the bankruptcy of Swissair in the beginning of 2002. Only a year earlier, the carrier had a strong (A3) rating from Moody’s before the situation deteriorated quickly.
Agencies also are not immune to suggestions of conflict of interest, given that the cost for ratings is usually paid by the issuer (issuer-paid model). This can lead to perceptions of favouritism, i.e., that the agencies assign ratings that please the issuer.
Ratings from Swiss banks are also exposed to a potential conflict of interest, as they are cross-financed via fee income from bond transactions. This might raise suspicions that the bank could theoretically issue better ratings in order to be awarded the assignment for the issuer's bond transactions.
How important are ratings to investment decisions?
While ratings tend to address default risk, investment decisions for bonds usually depend more on the assessment of temporary market risks. Investors assess whether they are sufficiently compensated for bearing the market risks with the current credit-risk premiums. Market risks are mainly concerned with sectors, countries, sustainability and bond-specific aspects.
The bottom line? Investors need to consider credit ratings in their assessments, but they must not shirk their responsibility by basing their investment decisions solely on ratings.
How ratings are createdRatings result from the evaluation of the business and financial profile. The business profile includes sector-specific characteristics (cyclicality, market entry barriers, consolidation/fragmentation), market position, diversification, country risk, regulation and governance. The financial profile includes management’s financial policy (aggressive or conservative), the company’s size, profitability, cost structure, cash flow generation, capital intensity and capital structure. It also reflects credit metrics with a focus on net debt, as well as debt and interest coverage. While agencies adopt different rating scales, there is equivalence across them that facilitates comparison (see table). In general, there are two important categories: investment grade and non-investment grade (aka speculative grade, junk, high yield). Investment grade refers to relatively strong credit quality above Baa3 (Moody's) or BBB- (S&P and Fitch). Issuers in the non-investment grade (below Baa3 or BBB-) have a higher default risk and less capacity to absorb economic or financial shocks.
Source: S&P, Moody’s, Fitch
Different types of ratingsRatings are assigned to both issuers and bonds. Bond ratings assess the creditworthiness of an issuer with regard to a specific bond, considering aspects such as collateralisation and seniority within the capital structure. In fact, it is possible for the same issuer to be in the bond market with several credit ratings: e.g., its issuer rating, and the different ratings for its senior secured bond, senior unsecured bond and subordinated unsecured bond. Guarantees or collateralisation of bonds can play an important role as they allow issuers to borrow money at lower interest costs while offering investors greater security. Companies in financial difficulty often resort to secured bonds, as investors would otherwise demand high coupons on unsecured bonds. The rating of secured bonds is often higher than that of the issuer and its unsecured bonds. In contrast, there are subordinated instruments, such as hybrid bonds, that have characteristics of debt and equity and are therefore subordinated and lower rated. While they usually come at a higher interest cost for the issuer, hybrid bonds are recognised as equity in the financial statements. Rating agencies usually treat them partly as equity, with positive implications for credit ratios. Finally, a distinction is also made between long-term and short-term ratings. Short-term ratings are primarily used for money-market investments with a term of less than 12 months and focus on short-term obligations. Classic bond portfolios, on the other hand, usually consider long-term ratings. |
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[1] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
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