In a time of looming economic uncertainty, its helps to understand the intricacies of bond ratings and associated risks
By Manuel H. Lazerov
Investment returns on fixed income securities have been declining, and all indications are that this worldwide trend in rates will go lower. Central banks, such as the ECB appear on the verge of greater quantitative easing.
Financial institutions, pension funds, and individual investors are feeling intensifying pressures to meet targeted investment objectives in a low interest rate environment. Consequently, it is not surprising to see numerous articles about greater investment interest and a noticeable shift to lower quality bonds and private debt, which provide greater returns.
I spoke with Andreas Heine, Head of Business Development for North America of international ratings firm Scope Ratings for his thoughts. His first impression was to offer some fundamental understanding of ratings. Bond ratings, he said, are a momentary indication of the risk associated with a particular security, and that the lower the rating, the higher an interest rate would be to compensate for risk, which in turn generates a higher “yield.” If a bond were to be downgraded, that is its credit rating lowered, the bond price would decline. So, there’s a two-fold exposure here, the market price of the bond, and its income. The liquidity of the bond is a third factor, especially with smaller issues.
What Mr. Heine observed is that, today, yields are declining to historic lows, which has created an appetite for lower rated securities with higher yields. He is concerned of the inevitable impact that an eventual recession will have on the values of lower rated securities. There’s a reason for a lower rating, which could be affected by an even lower rating during a recession.
Scope’s project finance team, led by Carlos Terre has developed a rating methodology with a ratings focus on the expected loss for an investor exposed to project finance credit risk. This is an innovative analytical approach, which provides a valuable alternative to existing credit opinions in infrastructure and project finance. This rating approach is getting increasing acceptance.
Is there a need for new infrastructure and project finance ratings? Scope offers credit analysis which addresses the ultimate risk for investors: the risk of a loss, rather than the probability of default-events, which will often only result in some form of restructuring, frequently with limited or no impact upon senior creditors.
In Scope’s and Mr. Terre’s opinion, rating approaches which focus solely on assessing a probability of default leaves investors wondering what will happen to their investment. Scope’s infrastructure and project finance ratings reflect the expected loss associated with payments contractually promised by the legal maturity, and accounting for the time value of money at the rate promised to the investor. This is more comprehensive than what one normally focuses upon.
What key aspects make Scope’s project finance rating approach different? According to Mr. Terre, “Scope pays equal attention to the likelihood and the severity of the credit impairment events which may result in losses for an investor, offering an analysis of recovery rates. We are thus able to reflect in our rating: events with potentially catastrophic severity, yet with remote likelihood (i.e. the black swans); as well as more likely events with mild severity.”
Manuel H. Lazerov is President of Infrastructure Financial, Inc. He may be reached at www.infrastructurefinancial.org.