Getting Insurance for Triple-A Ratings

Triple A Symbol Collapsing

Is a triple-A rating reliable? In some cases it is. In many cases it is not. Remember a few illustrious examples from 2008? As we know, a triple-A rating – indicating a prime investment-grade financial product or borrower – is issued when the corresponding Probability of Default (PoD) is judged to be very low. It is a well-known fact that credit rating agencies have been under fire because of conflicts of interest, misleading investors and, essentially, for triggering the 2008 global meltdown.

29d67-r2

What is needed, therefore, is a mechanism for checking the ‘strength’ of a rating, a sort of insurance policy. Such a mechanism exists and is based on Resistance to Shocks (RtS) ratings. Life expectancy (PoD) is one thing, the actual state of health (RtS) is another.

Credit Rating Agencies stratify risk (the Probability of Default) into numerous classes as shown in the table below.

pod

UR’s Resistance to Shocks ratings do not measure the creditworthiness of a borrower nor its probability of default. Instead, RtS ratings provide an innovative measure of the stability of a corporation (or an investment portfolio) in the face of shocks and turbulence. Therefore, the two cannot be compared and no correspondence should be attempted as these ratings provide totally independent information.

The table below illustrates the stratification of Resistance to Shocks ratings:

rts

In essence, an RtS rating is not yet another credit rating. However, it may be used to augment a conventional rating. In analogy to medicine, an RtS rating is not like a second opinion, it is more. It is a totally new piece of information. In effect, it is possible to pair these ratings so as provide an integrated PoD-RtS rating and to answer the question: how good is a rating? How strong is it? Consider the following extreme cases:

  • Prime investment grade & High Resistance to Shocks                         – ‘Strong AAA’
  • Prime investment grade & Low Resistance to Shocks                          – ‘Weak AAA’
  • Speculative grade & High Resistance to Shocks                                     – ‘Strong CCC’
  • Speculative grade & Low Resistance to Shocks                                      – ‘Weak CCC’

What these examples indicate is that a triple-A rating can hide fragility or that a triple-C rating may point to a situation of stability. In both cases, similar information is quite valuable. In practice, an RtS rating offers an additional discrimination mechanism when it comes to selecting stocks, asset classes or investment strategies. But not only that. An RtS rating offers an additional degree of comfort, a sort of insurance policy on top of a conventional PoD rating. Moreover, RtS ratings can be issued for portfolios, funds, funds of funds, bonds, national economies, systems of companies, etc.

We’ve analyzed almost 500 companies listed on the Dow, the S&P and the NASDAQ based on their quarterly fundamentals. The goal has been to actually verify if the above four situations are possible. Results are relative to Q3 2016. When we confront the two ratings, the situation is as indicated below (conventional ratings have been projected onto a scale from 0 to 20, where 0 corresponds to junk and 20 to Prime Investment Grade):

PoDvsRtS

Of the nearly 500 companies, 5 are Prime Grade (see red arrow), another 3 one notch less and 5 two notches less. With only one exception, all of these have an RtS rating of 70% or less. The majority of the companies have a PoD rating in the Lower and Upper Medium Grade with a spread in terms of RtS rating in the 55% to 90% range. Finally 73 companies have a rating that is below Speculative Grade. With one exception, most have an RtS rating ranging from 60% to 75-80%.

In essence, we have a triangular domain which prompts the following conclusions (NB these apply only to mentioned markets):

  • Triple-A ratings do not correspond to companies with the highest Resistance to Shocks rating (around 65%).
  • Companies with the highest Resistance to Shocks rating have a Lower and Upper Medium Grade rating. Here the RtS rating spread is from 55% to 90%. Hence, Lower and Upper Grade ratings are the strongest (most reliable).
  • Highly Speculative Grade ratings may, however, point to situations of relative stability (around 70%, even up to 80%). In other words, there is ‘stable junk’ out there.

The main conclusion of the study – which we are currently extending to all listed companies (approximately 45000) – is that triple-A ratings are generally weak. But then, we already know that not all that shines is gold.

If you want your rating rated, contact us.

Download report.

 

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