Q&A: Seeing the Forest Through the Trees - Credit Ratings Underlying Factors

During our recent webinar, we discussed how the scores and factors underlying an issuer credit rating may help in providing an outlook on a firm’s credit performance. We dived into what underlying scores and factors are used in Corporates criteria, how they might provide additional insight on rated credits, and how market participants can incorporate insights from these scores and factors into their credit risk process.

Our speakers, Rick Kanungo, Global Head, Credit Enterprise Products, and Giorgio Baldassarri, Global Head of the Analytic Development Group, Credit Risk Solutions, share their answers to the top questions asked by your industry peers during this webinar.

Q. Have credit rating factors changed over time?

The S&P Global Ratings’ Corporate criteria used by analysts to assign an issuer credit rating have remained quite stable for several decades, but since the second half of 2013, rating analysts have added further transparency by discussing and reporting explicitly all the underlying scores and factors that form an integral part of the rating process.

Q. Are there any credit rating factors that S&P Global Market Intelligence finds to be a bigger driver of probability of default? It seems that leverage is less meaningful today than it would have been pre-2008, but interest coverage is still very important.

Some drivers are not uniform across the credit spectrum. There may be greater drivers in the sense that business risk may have more sensitivity in the investment-grade part of the spectrum and financial risk is more sensitive in the speculative-grade part of the spectrum. So, how meaningful is leveraging? In 2008, leveraging was at the forefront with banks being highly leveraged but now, banks are better capitalized. When going back to the financial risk ratios mentioned, there are about two core ratios and five supplemental ratios. The core ratios are cash flow and liquidity based so funds from operations and debt are the two core ratios. Then, there are supplemental ratios and by going industry by industry, the thresholds can vary. In summary, you can’t just focus on your leverage but also look at interest coverage, cash flow, and most importantly – business risk scores.

Q. How and where would you get COVID-19-related projections? How do you incorporate the data in your analysis?

While COVID-19 is a global issue, the impact of COVID-19 is region-specific, and could be industry- and company- specific as well. So, it is not possible to say there is a COVID-19 factor as it is a fast changing and evolving situation. We would point to mentions of COVID-19 within research which would point to how a credit may or may not be impacted and to what extent from COVID-19.

There is not a lot of history with the pandemic to rely on and build out algorithms, but in terms of automation and scanning through research on RatingsXpress, we have the research available in XML over feeds available in bulk. We have many bits of research, including the downside scenario, upside scenario, outlook, and more in different fields to run targeted queries.

Since the final rating of a company depends on other components, such as modifiers, are these elements factored into the analysis?

After the calculation of the anchor, there are further modifiers and support considerations that are used to modulate up or down the initial anchor. This analysis focuses on and highlights the important role played by the financial risk and business risk. We could repeat the analysis by looking at the modifiers, but we are aware that these are really modulations on top of an anchor, so we do not expect the modifiers to disrupt our results.

Can one leverage this analysis for stock portfolio selection?

This is something we are looking into. Stock portfolio selection is more of an art than a hard science. One could use the underlying factors and our analysis to construct an appropriate portfolio and seek alpha. An alternative could be to leverage our analysis on bond portfolios since bonds are inherently linked to credit risk.