The Securities and Exchange Commission (SEC) issued a press release today announcing that it had removed “credit ratings as eligibility criteria for companies seeking to use ‘short form’ registration when registering securities for public sale.” The SEC unanimously voted for the adoption of this new rule, in response to the Dodd-Frank Wall Street Reform and Consumer Protection Act that encouraged financial regulators to rely less on credit ratings.
How should an investor interpret credit ratings? Check out what Standard and Poor’s says on its website:
Ratings should not be viewed as assurances of credit quality or exact measures of the likelihood of default. Rather, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue. (Credit Ratings Are Expressions of Opinion About Credit Risk)Two expressions to note are “[ratings] should not be viewed as assurances … or exact measures” and “ratings denote a relative level of credit risk.”
Firstly, while the ratings are not exact measurements of likelihood of default, they are qualitative expressions of likelihood of default. According to Standard and Poor’s, a security with an AAA rating means that the issuer of the security has an “extremely strong capacity to meet financial commitments” while a security with a BBB rating means that the issuer of the security has an “adequate capacity to meet financial commitments” (Credit Ratings Definitions & FAQs). Secondly, not only are ratings qualitative expressions of likelihood of default, they are relative expressions. A security with a rating of AAA means that its issuer is considered more creditworthy than the issuer of a security with a credit rating of, say, BBB, or that the credit quality of the former issue is considered higher than the credit quality of the latter issue.
While credit ratings of individual securities are assigned by private rating agencies, bond mutual funds report an ‘average credit quality’ statistic which is not assigned by private rating agencies, but is calculated by the funds as a weighted average of the credit ratings of the individual securities held by the funds.
What do the average credit quality statistics, given by mutual funds that are trying to sell themselves, tell us about the true credit quality of the mutual funds? If you are interested in our findings, read our paper on the topic of mutual fund average credit quality. Investors are invited to visit our dedicated website for more papers and up-to-date news.