By Judith Bloomfield, Contributor THERE are many issuers of bonds on the international capital market and, as a result, institutions known as rating agencies have emerged to help investors assess the risks associated with buying and holding these bonds. They do this by providing an objective and impartial third party opinion on the ability and willingness of an issuer to meet its financial obligations. In the process, they rate the issuers and their bonds according to the level of risk that they carry.
Rating agencies emerged in the United States near the end of the 19th century when, in 1909, John Moody a self-taught reformer who had a strong entrepreneurial drive and a firm belief in the needs of the investment community - published ratings of railroads and their outstanding securities. He later extended his analyses to that of utility and industrial bonds and bonds issued by US cities and other municipalities. By 1924, Moody's ratings covered nearly 100 per cent of the US bond market. In 1933, publishers Robert Dun and John Bradstreet merged their enterprises to form Dun and Bradstreet, which bought Moody's Investor Service 30 years later. Standard and Poor's Inc.(S&P), Fitch IBCA and Duff and Phelps emerged in similar fashion. Today, these four companies, led by Moody's and S&P, dominate the global credit ratings industry.
The rating agencies use alphabetical-numerical scales to quantify the level of risk associated with receiving full and timely payment of principal and interest on a specific debt obligation and how that risk compares with that of all other debt obligations. The highest rating a borrower can receive is 'Aaa' from Moody's and 'AAA' from S&P indicating that the issuer offers exceptional financial security or extremely strong capacity to meet its financial obligations. The lowest ratings are C or D Moody's and S&P, respectively given to issuers that are in default. In assigning a rating the agency considers the country's revenue stream and balance sheet, in particular the existing debt it has on its books and the burden of servicing that debt. Past financial performance is also considered: A country that has at any time defaulted on its financial obligation is seen inevitably as seriously credit-impaired and will receive a low rating. The agency must also examine whether there's a risk of changes in a government's economic policies, or whether a new administration might actually repudiate their country's debt.
It should be pointed out that the ratings are not totally reliable and may vary by agency. Take Jamaica's rating of B+ by S&P. That rating suggests that the country is more vulnerable to nonpayment but is currently able to meet its commitments, although adverse economic conditions are likely to impair the country's ability or willingness to continue to do so. Moody's rating, on the other hand, is higher at Baa3 and suggests that adequate financial security is offered, although certain protective elements may be lacking or may be unreliable over any great period of time.
Rating agencies play a low-profile, but high-impact role in today's capital markets. The rating received by a country is a major factor in that country's ability to raise funds and, to a great extent, establishes the rate of interest they must pay to obtain credit or issue bonds. A low credit rating will mean that, in order to persuade people to buy the bonds, the interest rate has to be very attractive that is, worth the risk. Additionally, a simple downgrade, even in only outlook, may trigger a sell-off by investors, making a bad situation even worse. For example, in December 2002, S&P revised the outlook assigned to Jamaica's long term local and foreign currency sovereign credit ratings from "stable" to "negative". This was an indication that the country rating may be lowered at the next review and resulted in foreign investors selling their holdings. Since there was tight liquidity in the Jamaican system, local institutions were unable to purchase the bonds causing the prices to fall. Moody's, on the other hand, maintained their stable outlook on Jamaica and this gave some support to the bonds when that news was released.
If Jamaica's rating is at all downgraded, this would mean that subsequent bond issues would have to be at higher coupons - thus increasing the government's debt burden even more. A lower credit rating would also reduce the market for Jamaica's bonds, as many potential investors are not prepared to take on such high levels of risk.
Judith Bloomfield is Operations Manager at Sterling Asset Management Limited.
