Credit ratings are not indications of investment merit

Adriaan Pask

Credit ratings can also speak to the credit quality of an individual debt issue (such as a corporate note, a municipal bond or a mortgage-backed security) and the relative likelihood that the issue may default. Ratings are provided by organisations such as Moody's, Standard & Poor's, and Fitch. These are commonly called credit rating agencies, and each applies its own methodology.

The reasons for ratings adjustments vary. They may be broadly related to overall shifts in the economy or business environment, or more narrowly focused on circumstances affecting a specific industry, entity or individual debt issue.

Business climate

In some cases, changes in the business climate can affect the credit risk of a wide array of issuers and securities. For instance, new competition or technology - beyond what might have been expected and factored into the ratings - may hurt a company's expected earnings performance. This could lead to one or more rating downgrades over time.

Growing or shrinking debt burdens, hefty capital spending requirements and regulatory changes may also trigger ratings changes. While some risk factors tend to affect all issuers - an example would be growing inflation that affects interest rate levels and the cost of capital - other risk factors may pertain only to a narrow group of issuers and debt issues.

For instance, the creditworthiness of a state or municipality may be impacted by population shifts or lower incomes of taxpayers, which reduce tax receipts and the ability to repay debt.

Since there are future events and developments that cannot be foreseen, the assignment of credit ratings is not an exact science. For this reason, ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default.

Relative opinions

Instead, ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest, within a universe of credit risk.

While investors may use credit ratings when making investment decisions, ratings are not indications of investment merit. In other words, the ratings are not 'buy', 'sell', or 'hold' recommendations, or a measure of asset value. Nor are they intended to signal the suitability of an investment. They speak to one aspect of an investment decision - credit quality - which in some cases may include a view of what investors can expect to recover in the event of default.

In evaluating an investment, investors should consider more than credit quality. They should also look at the current make-up of their portfolios, their investment strategy and time horizon, their tolerance for risk, and an estimation of the security's relative value in comparison to other securities they might choose.

By way of analogy, while reputation for dependability may be an important consideration in buying a car, it is not the sole criterion on which drivers normally base their purchase decisions.