What credit ratings reveal about equities
This week we have Tim O’Brien, analyst and VP of Industrials, Global Corporate, at Dominion Bond Rating Service (DBRS). A few months ago, I made a comment on air that credit analysts are often well behind the curve, meaning they don’t change their credit rating until the stock has significantly declined. I experienced this while I was a bond strategist for CIBC World markets between 1997 and 2006, and we saw how poor a job credit rating agencies did in the U.S. housing debacle in 2008-09. This opened a conversation with DBRS and ultimately led to today’s educational topic: How can following credit ratings help understanding the risks to your equity holdings?
We are now in a rate hike cycle and we can expect a recession at some point in the next few years. While there is little evidence of one today, looking at weak balance sheets tell us how stocks could perform in a bad economic environment. We have seen energy stocks with the most leverage perform quite poorly in the past few years as oil prices have declined.
What can an investor learn about a company from DBRS that she/he will not already know?
Credit ratings can help investors to get a sense of how risky a company’s credit profile is, which can be a very different and useful perspective to complement equity forecasts and price targets.
Credit ratings are primarily based on the assessment of two things: 1). the company’s business risk profile and 2). the company’s financial risk profile. The full analysis includes many more dimensions, including the discretion of the sector specialists/analysts and the rating committee members.
AAA = highest credit quality – unlikely to be adversely affected by future events.
CCC/CC/C = very highly speculative credit quality – there is a danger, but not a certainty, of default.
Credit ratings agencies rely on trends (upgrades vs. downgrades). There is a big difference in risk between a BBB company with good prospects and a B company with good prospects.
Why is it that sometimes a stock price or the yield of a company’s bonds can rise or fall without any change in the DBRS credit rating?
DBRS credit ratings reflect the fundamental credit health of the company, while stock and bond prices fluctuate for all kinds of reasons, including market fears/sentiment. The next time an investor sees market prices falling dramatically and is worried about whether a company might default, they should take a look at the DBRS rating to get an expert view on the underlying credit strength.
What information is available to investors who aren’t DBRS subscribers?
A lot is available from www.DBRS.com:
- All public ratings with trends
- All press releases, which summarize our main views on the company’s credit health and what we considered when determining the rating
- All of our methodologies which include the tools we use to determine each company’s business risk rating and financial risk rating
Can an investor use tools from DBRS to understand how a rating was determined?
Suppose an investor wants to estimate a rating of a certain manufacturing company, and/or understand why DBRS rates the company at “B” = highly speculative
- Go to www.DBRS.com
- Click “Understanding Ratings”
- Click “Methodologies”
- Click “Corporate Finance”
- Click Methodology for “Rating Companies in the Industrial Products Industry”
- Scroll down to “Primary BRA Factors” (BRA = Business Risk Assessment). For each factor, choose the rating that seems appropriate. For example, under Competitive Environment, if the company is among the key players in the market and has good brand recognition, you might choose BBB for that factor
- Then scroll down to “Primary FRA Factors” (FRA = Financial Risk Assessment). Calculate each primary metric, and then check to see which range it is in. For example, a Cash Flow to Debt ratio of 25 per cent would be in the BBB range. Definitions of the ratios can be found in the appendix of the methodology.
- After estimating the ratings for business and financial risk factors, an investor will be able to get a rough estimate an overall credit rating, keeping in mind that the business risk factors usually will be given greater weight when combining to get a final rating (although financial risk becomes more important as the ratings get lower into high-yield territory).
If the estimated rating is very different from the current DBRS rating, the investor should investigate why. This is an excellent exercise for an investor who wants to check if he or she really understands the credit risk associated with their investments.
Our upcoming seminar series is underway. We will look at all the different types of bond ETFs and teach you what types of ETFs to use is different types of economic environments over the next few years. Register free at www.etfcm.com. We ask BNN Viewers to make a voluntary charity donation to support Alzheimer’s research at Baycrest Hospital or Cancer research at the Hospital for Sick Children.
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