Introduction to ratings

In the European Union, credit ratings are defined as “an opinion regarding the creditworthiness of an entity, a debt or financial obligation (…) using an established and defined ranking system of rating categories”. In other jurisdictions, similar definitions apply of credit ratings apply.

Credit rating agencies use “rating methodologies” to derive the individual ratings. These methodologies describe the key factors and criteria used by a specific agency to derive its evaluation. These methodologies usually include quantitative and qualitative factors.

From a quantitative perspective, agencies usually use 3 to 5 years of financial information to derive the historic performance. Some agencies may equally include financial projections for a 3 to 5 years horizon. Financial ratios used for the assessment may differ from agency to agency (the definition of each of these ratios may equally differ and may include some adaptations by the agency).

Qualitative factors may include amongst others the following topics:

Governance of the issuer (also referred to Corporate Governance scores)
Industry risk: depending on the industry, risk drivers may substantially differ.
Competitive position of the issuer
Legal framework
Country risk: depending on where the issuer is located, country risk may impact differently. Note that some agencies apply the concept of “sovereign ceiling” capping the rating of an issuer at a country specific rating level (this level may correspond to the Sovereigns rating but can also be higher by some notches).

Based on these 2 dimensions, credit rating agencies may assign a “stand-alone rating” (sometimes also called Financial Strength Rating).

Thereafter, credit rating agencies may consider potential external support, such as shareholder guarantees, third party guarantees or implicit/explicit government support to derive a final rating.

Market segments

Credit ratings are assigned to a variety of issuers. In the European Union, ESMA currently uses the following market segmentation:

Sovereigns and Public Finance
Corporates: this category covers Banks, Insurances and non-financial Corporates
Covered Bonds
Structured Finance

Given that risk drivers and risk profiles of the above market segments are highly different, we strongly recommend carefully reading the specific rating methodologies to understand the approach and reasoning of each credit rating agency.

While the above market segmentation is not applicable in all jurisdictions, we use at RATINGPLATFORM this broad segmentation. Given the size and importance of the sovereign debt asset class, we have extended the classification by including also “political risk” assessments.

Types of ratings

Next to the credit ratings, credit rating agencies may produce additional assessments and provide additional services. While there is no uniform terminology used by credit rating agencies, the following products can be identified:

Indicative rating: based on limited information and a limited rating process, a credit rating agency may provide to an issuer an indication where the rating could finally end. These rating indications are usually done at the level of the rating category and therefore contain a rating rating.

Preliminary rating: is based on a full rating rating process. The rating is conditional only to material adverse change in financing terms and conditions.

Rating impact analysis: a rated issuer may request the rating agency to analyze potential future scenarios (eg due to M&A activity).

Point in time rating” is a credit rating relating to a specific point in time. The rating is not being monitored nor updated.

Risk Assessments: a credit rating agency may analyze the risk profile/risk drivers of an entity without a credit rating being requested.

Private rating is a credit rating disclosed only to a limited number of users.

Industry Risk Assessment: some agencies may assess a whole industry instead of single issuers.

Asset management rating: while these ratings don’t relate to credit risk, some agencies may provide assessments on asset managers (usually using a different rating scale)

Further services provided may include Corporate Governance scores, market implied ratings and credit scores.

Rating Scales

Only few jurisdictions (notably Chile and India) have standardized the rating scales to be used. We consider the following rating scale to be the traditional scale: AAA, AA, A, BBB, BB, B, CCC, CC and C. Note there may be difference between the CRAs in the number of categories in the C region as well as in the number of notches. Credit Rating agencies may equally use totally different rating scales. We therefore recommend to all users to familiarize with each CRA’s ranking system and the meaning of each category/symbol.

In order to make information more comparable across agencies, RATINGPLATFORM introduced certain standards. Credit ratings are usually defined according to two dimensions: time and currency.

We use the following abbreviations to denote these ratings:

FC: stands for “Foreign Currency” ratings and takes into account the transfert and convertability risk of the respective country

LC: stands for “Local Currency” ratings and refers to indebtedness in the currency of the issuer.

ST: stands for “Short Term” ratings and assumes a time horizont of up to a year

LT: stands for “Long Term” ratings and usually refers to a period of 3 to 5 years.

The prime reference for credit ratings is the Foreign Currency Long Term Ratings (“FC LT”). Next to credit ratings, agencies may assign additional ratings to an entity:

National Ratings (“Nat”): agencies may use a national scale for specific countries. These scales usually include a country code in order to identify them easily

Regional Ratings (“Reg”): Countries are often regrouped accordingly to regional critieria. Agencies may also assign ratings on regional scales. These scales are denoted with a regional code

Stand Alone Ratings (“SAR”): these ratings usually take into account an entity’s intrinsic financial standing, without considering any support granted.

Support Rating (“SUR”): next to the Stand Alone Rating, agencies may consider the support in case of stress. Such support may lead to an upgrade of the Credit Rating

Business models of rating agencies

Credit Rating Agencies may operate under highly different business models. We classify agencies currently according to 5 types:

Issuer-pays model: the rated entity (the issuer) requests the rating from the rating agencies and actively participates in the rating process (e.g by providing additional confidential information, holding management meetings). The rating agency publishes and disseminates the rating. Depending on the agency, rating reports may be freely available at the CRAs website , require registration or a full subscription.
Investor-pays model: the rating is request by an investor/user of ratings. Such investors usually request the assessment of a wide range of issuers within a specific asset class. The rating agency usually assesses the rated entities based on publicly available information (e.g. from stock listed companies) and is not in direct contact with the rated entity. The ratings are only made available to the requesting investor.
Mixed model: some agencies may derive their revenues from issuers as well as investors/users. These agencies are usually paid the rated entity, but the ratings are only available to users against a fee/subscription. In addition, some agencies may charge issuers and users differently depending on the market segment (e.g. issuer-pays for corporate and investor-pays for sovereigns).
Hybrid model: some agencies providing traditionally investor-pays ratings have started to propose selectively issuer-pays ratings.
Special model: some agencies may rate a specific segment of issuer under a special framework agreement. Some agencies may provide rating services to underpin their research, their activities on other areas. Finally, some central banks also act as rating agencies.