BY MUTHU RAMAN

In the previous few articles in this column, we looked at the capital markets and its two major components—the equity markets and the debt markets and the evolution of credit ratings.

In today’s article, we will explore what the rating symbols signify, what the rating scales are for different rating agencies and what meaning can be derived from the same.

Rating scales

A credit rating is an informed opinion on the relative likelihood of debt instruments being serviced ie interest and principal being paid on time and in full. Either the debt instrument or the debt-issuing entity may be rated.

The purpose of ratings is to provide investors with a simple system of gradation by which relative creditworthiness of securities may be noted within the defined frame of reference (such as a nation, a region or the globe).

Since the ratings are “current” opinion of the rating agencies, ratings can move up or down over the life of the rating.

A simple alphanumeric symbol is normally used to convey a credit rating. The rating symbols of most rating agencies are similar, except for minor variations. The typical long-term rating scales for three global rating agencies and the Caribbean region’s only rating services company CariCris, are in the table below:

n Standard & Poor’s Rating Services (S&P)

n Fitch Ratings (Fitch)

n CariCris may assign “+” or “–” suffixes from AA category up to CCC or C as may be applicable, to denote relative creditworthiness within the category.

n Moody’s Investor Services (Moody’s) assigns “1”, “2” or “3” to denote the same from Aa up to Caa.

Frame of reference

Rating symbols across rating agencies are not strictly comparable as they may be defined under different frames of reference.

A rating on the global scale compares the rated debt instrument with all debt instruments across the world. The global rating scale used by S&P and Moody’s are examples of this.

A rating on a regional scale compares the rated debt instrument with other debt instruments in the defined region, thereby providing finer distinction in credit quality among securities/borrowers within this region.

CariCris’ regional scale ratings compare the rated entity with other entities in a selected Caribbean region. CariCris is the first rating services company in the world to offer credit ratings on a regional scale.

A rating on a national scale compares the rated debt instrument with the instruments of other entities that are active in the financial markets of that country. S&P national scales for Canada, France, Mexico, Taiwan, Brazil, Argentina and Russia are examples of this. CariCris currently offers national scale ratings for three countries—Barbados, Jamaica and T&T.

Other nuances in ratings

While national scale ratings typically denote repayment ability in the local currency of the nation, regional scale and global scale ratings can denote ability to meet debt repayments either in local currency or in foreign currency.

While local currency ratings will be a reflection of underlying creditworthiness of the borrower, foreign currency ratings may additionally incorporate risks of foreign exchange restrictions that may be imposed by the sovereign, in times of distress.

Rating agencies operating in developed ratings market, such as Standard & Poor, also use “outlooks” to indicate which direction a change to a credit rating will likely take. The outlook can typically be “positive,” “stable” or “negative.”

Outlook should not be confused with “rating watch.” A rating is placed on a rating watch—with positive, negative or developing implications—when a significant unforeseeable event occurs, the credit impact of which could not yet be ascertained by the credit rating agency.

What ratings signify?

Relative creditworthiness, as indicated by credit ratings, can be measured in terms of either probability of default (PD) or expected losses (EL) or a combination of the two. The PD approach indicates the probability of the instrument not meeting its interest and/or principal on time, as promised.

The EL approach, in addition to assessing factors that may result in default, takes into account possible recoveries beyond default, through sale of the underlying security in the form of assets (if any) or recoveries from dissolution of the rated entity.

Globally, Moody’s states explicitly that its ratings indicate the ‘expected losses’ on the rated instrument, while other agencies such as S&P and Fitch adopt a combination of these two.

Can we compare ratings assigned by different rating agencies?

A few ground rules apply when comparing any two ratings:

No two rating agencies’ ratings are comparable, because these are “opinions” of the respective rating agencies.

All ratings assigned by an agency in the same scale are comparable irrespective of the sector, industry and geography. Thus, a “Cari AAA” in energy sector in Trinidad is comparable with a “Cari AAA” in banking sector in Barbados.

Ratings assigned in two different scales of same rating agency are not comparable. For instance, “ttAAA” by CariCris on T&T’s national scale is not comparable with a “Cari AAA” assigned in a regional scale, or “bbAAA” assigned in Barbados’ national scale.

To conclude, rating symbols indicate relative creditworthiness of securities within a defined frame of reference.

The rating scales of all rating agencies are similar, though the underlying meaning they signify may differ and individual ratings are not strictly comparable across rating agencies.

In the next article, we will explore how credit ratings contribute to the development of debt markets and specifically, the role of a regional credit rating services company in the development of a vibrant Caribbean capital market.