Risk rating agencies... a topic of interest for investors

By: Charles P. Morris*

Suppose that you are an average citizen, a person who has worked hard for, let’s say, about 10 years. You are paying some debts, the mortgage on your home being the most significant. Nevertheless, you have successfully planned your financial future and now have some extra cash saved and wish to invest it wisely and receive a good return in exchange. What is the first thing that you should learn before investing, in buying stock in a company, for example? The ideal would be that somebody could provide objective advice on, first of all, what type of company you should invest in, or, the creditworthiness of that particular company. This way, you could make a better decision regarding which company would be a good investment opportunity for your hard-earned money.

This risk evaluation is, in general terms, the type of work done by independent rating agencies that fully assess the credit quality of diverse companies, by request of the same, in order to satisfy the demand of global investors. Why would a company want to be “rated"? Wouldn’t it be better if the company notified investors directly on the company’s risk factors? Nowadays, this is not so easy! Ordinary and institutional investors demand better information on the companies they will be investing in and, on many occasions, demand that these securities have an investment grade rating assigned by an internationally renowned rating agency.

Before we go on, it is important to be familiar with the top agencies that assign investment ratings on the creditworthiness of governments, banks and private companies. The most popular rating agencies for investors in the securities market are Standard & Poor’s, Moody’s Investor Services and DCR Duff & Phelps Credit Rating Co. (previously Duff & Phelps).

Risk Ratings for banking institutions
Just as governments and diverse companies world-wide request risk ratings, so too do banking institutions, mainly because having a risk rating provides better possibilities of having access to a much wider group of investors in the international capital markets, allowing greater financing than in the local markets, and reducing the borrowing costs.

Today, it is essential to obtain a favorable credit rating from a professional credit rating agency in order to have access to international markets and to obtain funds from global investors. This is due to, as we have mentioned before, the large scale investments carried out in sophisticated capital markets, in which the investors avoid unnecessary risks, preferring to base their investment decisions on independent and impartial opinions elaborated by well known credit rating agencies.

In Latin America, including Panama, this practice has not been fully implemented. There are certain companies that seek out ratings; but generally, these are the exception, and not the rule. The reason? Mainly, it is because the capital markets in the region are still in development and, therefore, the parameters on this type of information are much more flexible. In Panama, two different banks have been rated: Banco General S.A., which was assigned a BBB qualification from DCR Duff & Phelps Credit Rating Standard Co. and BBB- by Standard and Poor’s, and Banco del Istmo S.A., which was assigned a risk rating of BBB- by DCR Duff & Phelps Credit Rating Co. Both ratings were well received by the capital markets.

In the case of Banco General, it is important to point out a fact of great significance within the general context of the ratings at a global level. Until 1997, the year in which Banco General was assigned its "initial rating", there existed an intrinsic rule that had never been broken: an issuer of a country could never have a "rating" on its unsecured obligations that exceeded that of the sovereign risk of its own country. In 1997, Panama, as the sovereign, enjoyed a BB+ credit rating, whereas, Standard and Poor’s rated Banco General BBB-, without the Bank having to secure the issue. This resulted in Standard and Poor’s, for the first time, breaking the “sovereign ceiling” rule and rating a company better than its sovereign.

On November 30 of last year, and given the recent acquisition of Bancomer by Empresa General de Inversiones, S.A., another important event for Banco General and its investors took place. Standard & Poor’s reaffirmed its BBB- investment rating, ratifying its current outlook on the Bank as stable.

How does the credit rating process work?
Several different methods exist to assign a rating. A common method in evaluating risk is using criteria like Strengths, Weaknesses, Opportunities, and Threats (SWOT) Analysis. Other rating criteria to analyze risk are based on the qualitative and quantitative factors of a company, of which we can mention, among others, the following: the economic and financial aspects of the industry; the economic cycle experienced by banks or companies; competitiveness within the industry; cost structure; earnings outlook; the knowledge and the experience of its management team; the quality and the credit categories granted by the institution; and the structure and diversification of its mortgage lending portfolio, both personal and corporate. In the case of banks, perhaps one of the most important points that analysts observe is the paid-up capital, which determines the capacity of the issuer to repay its obligations in adverse or non-favorable industry cycles.

Generally, there are many factors that analysts of credit rating agencies take into account before expressing an opinion or investment recommendation on a bank, company or government. The truth is that when a rating agency is asked to carry out an evaluation, it is important to remember that their analysis of the company will be exhaustive. After all, the reputation of the credit rating agency will be on the line the moment an ordinary investor, after 10 years of hard work, decides to trust the independent criterion of the rating agency regarding the risks that this investment will involve.

* Financial Advisor, Wall Street Securities S.A.

	Rating Scale (DCR Duff & Phelps Credit Rating Co.)
	AAA: Highest credit quality or optimal rating. Better known as "Highest Investment Grade". The risk factors for investors in this type of rating are practically null. This type of rating is compared to U.S. Treasury Bonds, which are considered a very safe investment.
	AA+, AA, AA -: High credit quality. Protection factors for investors are very strong. The risk is modest, but may vary from time to time due to economic conditions.
	A+, A, A-: Protection factors for investors are good and adequate. However, the risk factors are variable in periods of unstable economies.
	BBB+, BBB, BBB -: Good credit quality that offers below average protection for investors, but considered by analysts as an acceptable and recommendable rating. This type of rating has considerable variability in risk during unstable economic conditions, but it is well viewed and accepted by analysts. Offers a good risk/benefit ratio.
	BB+, BB, BB -: This type of rating is below what is defined as "Investment Grade". However, it offers investors credibility as far as the payment of financial obligations held by the issuer. Investors who hold this type of rating in their portfolios must be mindful that economic or political conditions and industry cycles may affect the issuer’s capacity to meet its financial obligations.
	B+, B, B -: This rating is below "Investment Grade". A credit risk exists that the issuer may not meet its obligations when due. The protection factors for investors are contingent with the development of the company, the economic cycles that if faces, and the strength of its balance sheet. This type of rating changes frequently.
	CCC: This rating is well below "Investment Grade". Investing in this type of rating warns investors that their money runs a certain risk. Considerable uncertainty exists as to the capacity for meeting financial obligations and it is highly vulnerable for default. Investors must be conscious that the protection factors may be unfavorable if economic conditions are adverse and affect normal company developments.
	DD: Defaulted debt obligations. This rating is issued when companies have failed to make timely payments of principal and/or interest. Generally, the rates of return in this type of issues are high given the risk/benefit ratio.
	It is important to note that rating agencies use different symbols or degrees. Some use letters as representation of ratings, and others use a combination of letters and numbers. For more information, please consult with your financial adviser.