From Wikipedia: “A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. The credit rating represents an evaluation of a credit rating agency of the qualitative and quantitative information for the prospective debtor, including information provided by the prospective debtor and other non-public information obtained by the credit rating agency’s analysts.
Credit ratings can address a corporation’s financial instruments i.e. debt security such as a bond, but also the corporations itself. Ratings are assigned by credit rating agencies, the largest of which are Standard & Poor’s, Moody’s and Fitch Ratings. They use letter designations such as A, B, C. Higher grades are intended to represent a lower probability of default.”
The table below indicates how the top three rating agencies stratify the various rating classes.
Resistance to Shocks (RtS), sometimes known as resilience, or ‘shock-worthiness’, measures the capacity to absorb shocks or destabilizing events, such as financial contagion, stock market collapses, market bubbles, natural disasters or geopolitical events. It provides an indication of how stable a company, portfolio or market is and how it will react to the said events.
We have computed the Resistance-to-Shock ratings of approximately 40 public companies which are or have belonged to the Dow Jones Index. Quarterly Standardized Balance Sheets have been used for the purpose. We have compared these new ratings with the conventional Probability-of-Default (PoD) ratings. As RtS ratings span the 0%-100% interval it is easy to compare them with their PoD counterparts even though we’re talking of two totally different quantities which cannot be compared directly as they reflect different aspects of the state of heath of a company. In order to force the ‘comparison’ we have ranked the conventional rating from 1 – junk – to 20, top investment grade. The table below lists the said companies from highest PoD rating to the lowest.
Only one company is close to non-investment grade and that is Alcoa. A better view is offered by the scatter plot shown below.
What is interesting to note is the large spread between the highest and lowest PoD ratings, spanning practically half of the entire range. The RtS ratings, on the other hand, are less scattered. Secondly, some PoD ratings appear to be overly optimistic, especially with Oil & Gas companies. RtS ratings, which range from approximately 60% to 75% (with the exception of AIG), are more in line with the state of the global economy. The fact that RtS ratings enjoy a lower spread than their PoD counterparts may be due to the fact that in a highly interdependent economy things tend to level out. A bank cannot be very healthy if most of its clients are in trouble…. Basically, we’re all on the same boat.
It is also interesting to observe the difference between rating distributions. Both are positively skewed, although the small sample size (around 40 companies) is too small to make any definitive statements.
One may have expected more correlation between the two ratings. It is a good thing that there is no such correlation. Had there been a strong correspondence one of the two ratings would be useless as it would essentially repeat the information offered by the other. In effect, the PoD and the RtS are two unrelated measures, almost ‘orthogonal’ to put it in the language of mathematics.
What is, however, clear, is that in the case of very high PoD rating, 17 through 20, the RtS rating has very little scatter. In other words, highly PoD-rated companies all have a similar RtS rating – around 70%. In the case of PoD ratings below 16, the RtS rating begins to scatter significantly. In fact, in the case of AIG, the disagreement is rather pronounced – a PoD rating of 12, not so far from non-investment grade, while the RtS rating is 86%, the highest of the entire Dow.
We have also analyzed the system of all the mentioned companies, taking into account all the interactions (over 4 million) established based on the respective fundamentals (over 2700 balance sheet entries). In essence, its like considering these companies as one single ‘mega-corporation’. The resilience of this system is 73%, 3% above the average Resistance-to-Shocks. The Complexity Profile, illustrated below, reflects the percentage contribution of each company to the complexity (and RtS rating) of the ensemble.
The companies at the top of the chart have a larger complexity footprint (around 3.5%), i.e. capacity to generate complexity, than those close to the bottom (around 1.%). The above information can be used in the design of resilient and sustainable investment portfolios.
As the PoD increases, our RtS metrics begin to scatter suggesting that our model-free approach is extracting additional objective information from the company fundamentals which form the basis of RtS analysis. The range of RtS values we have found in this particular case – between 62% and 86% – points to a relatively healthy situation. The World, as a system, boasts an RtS of 81%, while the Eurozone a mere 50%. It is important, however, to keep in mind that the RtS is not directly linked to performance as it reflects the ‘resistance’ a company or macro-region will be able to offer in case of a destabilizing event or a shock.