• Warren Buffett
  • Volvo
  • NASDAQ Composite Index
  • 10 Year Treasury
  • Commercial Banks
  • JPMorgan Chase
  • Emerging Markets
  • Commerce Department
  • Stock Market
  • Home
  • Practice Management
  • Research & Insights
  • Alternatives
  • ETF Managed Portfolios
  • Home>Research & Insights>Gray Matters>Another Vote for Market-Based Measures

    Related Content

    1. Videos
    2. Articles
    1. Practical Strategies for Today's Bond Market

      The outlook for bonds is just as cloudy as ever, but Morningstar's Miriam Sjoblom and Marta Norton offer helpful tips for setting the right expectations and creating a game plan in today's challenging bond market.

    2. Ready Your Portfolio for Retirement

      Morningstar's Christine Benz demonstrates how to make a bucket portfolio best work for you, touching on allocation, RMDs, other income sources, and more.

    3. Bucket Portfolios for Retirement Income: Step by Step

      Morningstar's Christine Benz walks investors through the basics of setting up and maintaining a 'bucket' retirement portfolio, including some of her favorite funds for retirees.

    4. Top Investment Ideas for Retirement

      Retirement Readiness Bootcamp Part 5: Morningstar strategists share their top fund, ETF, and dividend stock picks to fill your retirement portfolio.

    Another Vote for Market-Based Measures

    How Morningstar uses market prices in its corporate credit ratings.

    Haywood Kelly, 03/07/2011

    This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription today! 

    When we developed the Morningstar Credit Rating for corporate issues in 2009, we had two goals in mind: be forward-looking and be timely. No one needed yet another rear- view mirror assessment of financial health. To make our ratings forward-looking, we used measures like our economic moat rating and our analysts' forecasts of cash flows during the next five years. To help ensure timeliness, we embedded a market-based measure of financial health--Distance to Default.

    As William Mast argues in "Redefining Credit Risk," with regard to credit default swaps, markets are often a leading indicator of financial distress. In many cases, market prices will reflect deterioration in a company's credit strength well before they show up in financial statements, analyst forecasts, or traditional credit ratings from the likes of S&P and Moody's. Based on our own backtesting, as well as a cottage industry of academic work, Distance to Default has proved a valuable early indicator of financial distress because it takes real-time market signals as inputs.

    Take Ambac, the only company with a Morningstar credit rating that defaulted in 2010. (We initiated coverage with a C rating in September.) The graph shows the deterioration of Ambac's Distance-to-Default score during its path toward bankruptcy. In February 2008, the probability of default for this insurer jumped to more than 55% from 17%, signaling severe financial distress. By contrast, it took S&P until June 2009 to cut its issuer rating on Ambac to below investment grade. Moody's was a bit quicker, cutting its Ambac issuer rating to below investment grade in November 2008.

    (View the related graphic here.)

    The market inputs fed into our Distance to Default algorithm are not CDS prices, but equity prices. For a debtholder, the equity of a company represents the cushion below you in the capital structure; as long as the equity has value, so do your bonds. The absolute level of the share price and the historical volatility of those share prices feed into the Distance-to- Default algorithm. As a company's share price falls, so does its Distance-to-Default score; likewise, the more volatile the company's stock, the worse the score. As a firm's equity cushion shrinks, or when there's great uncertainty as to the value of that equity cushion, the bonds become more risky.

    A practical advantage to using equity prices as our market-based indicator is that equity markets are extremely liquid, more so than the CDS market. Unless there is demand for the CDS of a particular issuer, a price won't be available. In the high-yield space, CDS availability is particularly spotty, and with one fourth of our credit-coverage universe rated BB or less, using CDS simply isn't an option. So, while CDS prices are extremely useful indicators when prices are liquid and available, they don't provide (yet, anyway) broad enough coverage for use in Morningstar's corporate credit ratings.

    Why not use bond prices, you ask? Our analysts also keep tabs on the price movements of the bonds of companies they follow, but we run into liquidity problems. A significant portion of corporate bonds sit snug on the balance sheets of insurance companies, pension funds, and other long-term institutional owners. Some bonds may not trade for months at a time, sapping any reported prices of their informational content. Equity prices are, again, a better all-purpose indicator of market sentiment.

    Haywood Kelly, CFA, is vice president of equity research at Morningstar.