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  • Home>Research & Insights>Gray Matters>Redefining Credit Risk

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    Redefining Credit Risk

    The credit-default-swap market may provide a viable alternative to credit-rating agencies.

    William Mast, 02/07/2011

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

    For more than a century, the big three bond-rating agencies--Moody's, Standard & Poor's, and Fitch--have been the unchallenged arbiters of corporate creditworthiness. Rating references are embedded in hundreds of guidelines, laws, and private contracts that affect a broad range of financial concerns.

    The financial crisis, however, laid bare a weakness in the credit-rating agencies' models: Their ratings are backward-looking because they are predicated on historical data that is observed at a discrete point in time. Given this constraint, the agencies have not been favorably positioned to react quickly to rapid changes in a creditor's financial health. Hence, evidence of accounting fraud in a company's financial statements may elude their scrutiny. Also, the agencies have demonstrated that they remain ill-equipped to assess the risks of some complex, structured products.

    There is now considerable momentum in the markets and on legislative agendas to explore alternative ways to assess the credit ratings of public companies. Independent credit research efforts--some housed under the same roof as the big three--have already broken the issuer-paid model and are using real-time market factors in their evaluations. In fact, recent research points to the credit-default-swap market as a source for a more fluid, market-driven metric to gauge the creditworthiness of an issuer.

    Market Indexes and Ratings
    The disconnect between the credit-ratings agencies and the market's risk perception is illustrated in the exhibit, which plots individual bonds' yield spread premiums--using the Morningstar Corporate Bond Index in early 2010--against a composite rating of Moody's, S&P, and Fitch. If we assume that any given rating is a uniform measure regardless of the industry or issuer, we would logically expect to see a much tighter range of yield spreads for any given rating. Where this is not the case, we can assume that the market's perception of credit risk is, to some degree, at odds with the current rating.

    If we conclude that there are viable alternatives to the rating agencies, we should also consider other options to the current offering of bond market indexes. The mainstream fixed-income indexes have always been defined by the rating agencies-- including Morningstar's indexes. This is most evident where the clear demarcation between investment grade and below investment grade has not faded over time. New index methodologies have always evolved with the markets. For example, as average issue sizes grew over time, the index providers increased the amount outstanding required for inclusion. And as smaller sectors matured and proved to have sufficient liquidity, they were added to aggregate indexes. To the degree that alternatives to the ratings agencies emerge, these new options should help define new indexes.

    Credit Default Swaps: A Worthy Market Measure?
    One main criticism levied at the rating agencies is the historical, point-in-time nature of their ratings. A better model for determining an issuer's creditworthiness could be derived from real-time information.

    For starters, a security's market price reflects the expected performance of the entity, the potential for performance to exceed or fall short of expectations, sector outlooks, geographical performances, the potential for surprises, and the security's liquidity. Market activity, such as trading volumes, historical trends, correlations, and volatility, adds to the picture.