Understanding Ratings

Ratings are an important tool all investors looking to put money onto deposit need to understand.

Thursday, 23 August 2007

• They are an opinion – not a guarantee
• Each rating organisation is different – understand what they do and how their scales work
• Ratings are generally giving a probability of default
• Investment grade doesn't mean an investment is safe. Likewise a so-called "junk bond" isn't necessarily a bad investment.

International agencies
The first group are the large international credit rating firms, Standard and Poor's, Fitch and Moodys. Currently the first two are active in the market and have rated a number of finance companies as outlined in the table below. Moodys doesn't appear to be offering its services in this market, however it does have ratings on a number of banks.

One of the big issues with these firms is understanding their ratings scales, as they are not particularly intuitive.

Ratings are done by letters and range from A down to E. With each letter there are three steps, eg: AAA, AA, and A. These steps can be further graduated with plus and minus symbols. For instance you can have AA+.

Where they become tricky to understand is that the order of priority is from a triple letter, eg BBB down to a single letter. This, along with the plus and minus symbols can give misleading perceptions.

For instance a BBB- rating is actually better than a BB+.

The other misconception is this view often perpetuated in the media that there is a line in the scale and anything above it is so-called "investment grade" and anything below it is a "junk bond".

Further confusing the situation is the view that junk bonds are bad and people should not invest in them.

The truth is that so-called junk bonds can have a place in an investor's portfolio as long as the reward is sufficient for the risk and that it has an adequate weighting in the portfolio.

Niche providers
The next group of ratings agencies are some local ones and two which are essentially Australian based. They are:

• Grosvenor Financial Services (Wellington) Bondwatch
• PIR (Melbourne)
• Axis Ratings (Wellington), licenced to use the Rapid Ratings process.
• FundSource (Auckland) FinanceWatch
• Project Resources (Kapiti Coast) Chris Lee.

In addition to the above accountancy firm KPMG produces its annual FIPs report and Wellington sharebroker McDouall Stuart produces an annual report on the sector. Neither are readily available to investors.

Ranker not Rater
The other service available is SQP that is produced by Interest. This system is designed to rank companies on their strength, quality and profitability.

This system is highly flawed as the information can be misleading. For instance Bridgecorp at one stage had an AAA ranking, while Nathans was a CAB.

It is also misleading as the process isn't clearly explained on the pages and it looks like a rating.

Depositrates has been highly critical of this system and believes investors should not use it. The system also has very little support from industry players.

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