Analysts use a rating scale in research when they intend to associate a qualitative measure with the various aspects of a product or feature. Rating agencies make use of a large number of different rating scales. Generally, rating scales are used to evaluate the performance of a financial product or service, employee skills, customer service performances, etc. An ordinal scale e.g. is a scale the depicts the answer options in an ordered manner. Rating systems have evolved in response to the increasing depth and breadth of the global markets. Much of the innovation in e.g. credit rating scales is a response to market needs for clarity around the components of credit risk or to demands for finer distinctions in rating classifications.
The clear divide between investment-grade and speculative-grade debt markets dates back decades.
A number of central banks make their bond purchase programs dependent on minimum credit ratings. These are often operationalized by specifying rating symbols, such as the rating symbols Baa3 or BBB-. When a rating agency tries to win paid orders from issuers by giving benevolent ratings above this threshold, it is damaging the system on a very fundamental level. The rating agency Moody’s Investors Service has now presented an in-depth analysis with which it shows – inter alia – why it takes this threshold so seriously.
“Between the 1930s and the late 1970s,” tells Moody’s, “investment-grade companies issued almost all public bonds in the US, and the speculative-grade (or high-yield) bond market consisted solely of companies that had been downgraded out of investment grade (i.e., fallen angels).”
According to Moody’s, it was not until the early 1980s in the US, and later outside of the US, that a robust speculative-grade public bond market emerged and grew rapidly, fueled mainly by private equity-sponsored leveraged buyouts. Since the 1980s, the high-yield market has continued to expand as its own asset class with distinct investor groups. As a result, a clear divide has been maintained between the investment-grade and speculative-grade debt markets.
The classification is still at least as important today as it was in the past. Increases in credit spreads and losses at the investment-grade/speculative-grade divide are relatively large. One factor underlying the importance of this divide is the relatively large percentage changes in corporate credit spreads and losses when moving from investment grade to speculative grade, and vice versa.
“The percentage increase in spreads moving from Baa3 to Ba1 is materially larger than at almost all other points on the rating scale,” says Moody’s, “both in the first half of 2021 and over a longer period from 1991 through 2020.” Another finding in Moody’s report: “The investment-grade and speculative-grade divide delineates a difference in historical credit losses between Baa3- and Ba1- rated nonfinancial companies that is larger than at most other points on the rating scale.”
According to the data published by Moody’s, these relatively large differences across the Baa3/Ba1 divide are long-standing. “Regulations and portfolio governance rules that hinge on the distinction between investment-grade and speculative-grade ratings have led to these differences and have driven differences in financial policies and liability structures.”
Stock instruments issued or to be issued and / or traded on certain stock markets may be the subject of ratings. Stock ratings reflect the risks associated with the creditworthiness of the issuer and the stock market liquidity of an instrument. However, they do not address the risk of loss associated with price changes and other market conditions, nor do they consider the reasonableness of prices for their market value. Ratings assigned at national level cannot be compared across borders and are assigned using national rating scales.
Such equity ratings are usually the result of regulatory intervention by the state to prevent investors and issuers from being harmed by malpractice on the stock exchanges. The requirement to issue equity ratings is therefore to be understood in some states as a reaction to regulatory requirements. To the extent that such requirements do not currently exist or are not applicable, share ratings are based on market practice.
Financial instruments affected by equity ratings include, but are not limited to, common shares issued by financial and non-financial companies. The equity rating method does not apply to shares issued outside of a public offer by private funds or other investment instruments, or to preference shares, as these are accessible through their own methodologies.
Stock ratings are about the elements to be valued as part of the stock rating process. Stock ratings are supplemented by analytical considerations regarding the issuer’s credit rating. The equity rating methodology should therefore not be viewed in isolation, but should be read in the context of the global criteria reports of ratings for financial and non-financial companies.
Share ratings are also referred to as buy, sell or hold recommendations. A strong buy recommendation can be expressed, for example, by a double plus ++ and a simple buy recommendation by a simple plus +, vice versa in sales recommendations minus – and double minus –. If the rater gives neither a recommendation to buy nor to sell, the recommendation “hold” e.g. can be expressed by a circle symbol o.
Analyst opinions expressed as buy and sell recommendations are as fast-paced as the stock market itself, as the Corona crisis recently showed: If the price of a share falls, the sell recommendation can quickly turn into a buy recommendation.
Because buy and sell recommendations depend on daily market price fluctuations, equity rating repair does not refer to the question of whether a stock is over- or undervalued.
Rating repairs therefore relate to the awarding of share ratings, which give investors an independent opinion on the creditworthiness of the issuer and the liquidity risk associated with their shares. The purpose of such stock ratings is to provide an estimate of the liquidity risk an investor takes when purchasing a particular stock security in order to measure, in a timely manner, how easy or difficult it will be to sell those instruments if the investor so decides.
The analysis includes evaluating the stock’s historical stock market behavior in relation to presence and traded volumes, as well as the relationship between the movements of the stock and the financial situation of the company and the industry in which it operates.
Creditworthiness and market liquidity risk are the most important factors in the equity rating for which evidence can be produced. At national level, equity ratings are therefore based on two types of analysis: issuer creditworthiness and market liquidity risk. The combination of these two factors leads to the determination of a company’s equity rating.
The purpose of a stock rating is not to assess the risk of default on such stocks. Shares are equity securities and they represent ownership, not just a claim. Therefore, they cannot be in default. Because stocks do not have specific payment obligations, the stock rating is about the likelihood that the issuer will continue to operate. Conceptually, equity ratings indicate that the more creditworthy an issuer is, the greater the likelihood that its shares will continue to be traded throughout the business cycle. In the current case of the bankruptcy of Wirecard, a company listed in the German stock index DAX, it would have been the task of a stock rating to signal the probability of such an event by a low rating.
Stock ratings reflect risks related to the creditworthiness of the issuer and the market liquidity of the stock. For the reasons outlined, however, they do not deal with the risk of losses associated with changes in share prices and other market conditions, nor with the adequacy of the market price of a particular security. Equity ratings are therefore notsuitable as trading signals, for example to buy and sell a stock within a few hours. Equity ratings are also not the basis for trading Contracts for Difference (CFDs). Under no circumstances does such analysis result in a recommendation to buy or sell a particular security. Share ratings are therefore not a special form of share price estimates, nor are share prices used to determine forecasts of liquidity risk.
The information required to carry out the risk analysis and assign ratings is obtained from various sources such as the issuer, industry data and other relevant sources. For the specific analysis of the liquidity of the share, the statistical data are obtained from market sources that are required to be able to calculate the relevant stock market indicators.
The analysis usually includes five years of company history and financial data. The information required to assess the creditworthiness of the issuer can be requested directly from the issuer or obtained indirectly through agencies. Once the necessary information has been collected and checked, an analysis can be carried out using a uniform method.
If criminal energy is involved – as allegedly in the case of the Wirecard company – the stock rating cannot easily detect the counterfeit. Rating agencies emphasize that the information received from the issuer or its representatives will not be reviewed or verified (again). While ratings look to the future, auditors’ attestations are there to confirm that the company’s report agrees with the facts it finds.
In order to counter fraud cases like WorldCom, Enron and now apparently also at Wirecard and to give warning signals to investors, a forensic rating is required. Forensic ratings typically deal with individual offenses, unlike criminology, which examines the basics of criminal behavior. The concept of “forensic science” – like the concept of “credit rating” – often does not meet the criteria for scientific research in the narrower sense. It is understandable that forensic ratings are predominantly carried out using methods that are well established, standardized and as undisputed as possible. Innovation and creativity must be severely restricted for reasons of comparability and fairness. The scientific principles of objectivity, reliability and validity also apply to criminal investigations. It is very important to ensure the highest possible quality standard as with every rating.
Rating also does not replace the work of the auditor, because the auditor’s report is the overall opinion of an auditor after the audit of the annual financial statements. In it, the auditor assesses the conformity of the annual financial statements and the management report with the accounting regulations applicable to the company. An assessment is only made as to whether the situation of the company has been correctly represented, but no prognosis of the company’s creditworthiness and the liquidity of the share is given. A holistic assessment of the economic situation, which also requires a considerable degree of industry knowledge, is generally not carried out. The auditor’s report may only be issued after the material examination has been completed.
For securities without historical stock market information such as a first stock offer or with insufficient information, the analysis can practically only be based on the creditworthiness of the issuer. After approximately one year of trading and records of stock exchange transactions, equity liquidity is included in the analysis.
The issuer’s creditworthiness is expressed in its issuer default rating or its long-term national scale rating. Depending on the type of company, these are calculated according to the respective methods for non-financial – e.g. Chemical companies, technology companies) and financial companies (e.g. banks and insurance companies).
As with credit ratings, the purpose of credit analysis is to classify the likelihood that a company will meet its financial obligations (or in other words, the risk of default). The company’s operational and financial profile, its overall creditworthiness and thus the long-term rating of the issuer are good approximations of the risk of a company’s future cash generation capacity.
The equity rating includes qualitative and quantitative variables to measure the operational and financial risks of an issuer and to determine its credit profile in accordance with the concepts contained in the global rating methods for financial and non-financial companies.
As already indicated, an ex-post analysis is carried out to assess exchange liquidity, which is naturally dynamic and is based on the monitoring of certain relevant market indicators for measuring the liquidity of a share.
The world’s stock exchanges are very different. What is relevant for investors is the quality of the paper on the stock exchange where it can trade. Therefore, stock ratings are placed in the context of the country’s stock exchange. The analysis may include elements that reduce liquidity, e.g. for example, the series of a particular share that grants greater rights to another series of that security. The relative importance of the individual risk factors can vary. As a rule, indicators that indicate the low liquidity of a particular stock limit their rating to the lowest range on the scale.
The trading history of the share, the percentage of free float and the development of market capitalization and daily trading volume are factors that influence the assessment of the liquidity level of the share. The liquidity of a security is measured by the recent development of these and other stock market indicators, but essentially by the presence of the security on the market. Although the rating depends on the recent performance of the equity liquidity indicators, the track record of the indicators being assessed is critical to determining a rating.
The market presence is the main measure that is taken into account when determining market liquidity. The number of days on which an instrument has been processed in relevant amounts within the last 180 working days plays a role here. This indicator provides a measure of the number of days on which transactions relevant to a share were registered.
The number of days on which an investor would have been able to get out is important for assessing the liquidity of a share. Companies in which transactions are recorded almost every day have a high stock exchange presence, which speaks for a high level of liquidity.
Market capitalization – and thus indirectly the share price – also plays a role in the share rating, because it reflects the market value of a stock corporation at a certain point in time. The market capitalization is calculated by multiplying the share price by the number of shares. By looking at the market capitalization, there is a ranking that the companies rank according to their market size. Rapid, frequent and unilateral changes in market capitalization reflect the trend and volatility of market value over a period of time.
The free float relates to shares that are not held by majority or long-term shareholders. Free float in stock corporations means the total number of shares available for exchange trading. The higher this percentage, the more liquid the share should be. When the trading volume is recorded, the total value of the transactions in a share is taken into account.
The average daily trading volume is determined by the presence on the stock markets and the market capitalization and reflects the monetary value of the average daily transaction volume for a specific security in a specific period. The trading volume is calculated by the number of securities traded in a period multiplied by the price of each transaction. The total volume traded by an issuer is compared to the total volume traded by the entire market.
Share ratings express the “option character” of a company’s shares. According to the option price theory, the shareholder can also be modeled as a buyer of a purchase option. By paying a premium – the share price – the buyer receives the right, but not the obligation, to continue operating the company. If the value of all the assets of a company falls below the value of the creditors’ claims against the company, the shareholder does not have to replenish equity, but can leave the company to the creditors for liquidation as part of an insolvency procedure.
Since the company’s credit rating also includes the risk of default, it characterizes the option character of the share. The lower the share rating, the greater the option character of the share.
On May 1, 2014, the German Central Register of Traffic (VZR) became the Driving Fitness Register (FAER). The existing scoring system was converted to the new driving fitness rating system.The basis for this is the fifth law amending the Road Traffic Act and other laws of August 28, 2013 and the Ninth Ordinance amending the Driving Licenses Ordinance (FeV) and other road traffic regulations from November 5, 2013.
A prerequisite for a scoring in the driving fitness rating system is on the one hand a listing of the infringement in Appendix 13 to § 40 FeV and in the case of misdemeanors on the other hand, the fine imposed at least 60 euros.
Unlike in the VZR, the FAER only records the decisions on misdemeanors which have an impact on the safety of road traffic. Administrative offenses such as the prohibited entry into an environmental zone are no longer stored in the FAER. Therefore, the decisions that were stored in the VZR until the end of the April 30, 2014 and that can not be saved according to the new rules for the FAER, were deleted on May 1, 2014.
Only the fact that the infringement is listed in Annex 13 to Section 40 FeV is decisive for the storage. In this context, however, it is not necessary for the fine to be at least EUR 60, since the registration limit at the time of the commission of the administrative offense (before May 1, 2014) was 40. euro.
However, fines that are no longer to be stored in the FAER are appropriately increased.The entries stored in the FAER are provided to the driving license authorities for the purpose of checking the fitness to drive.
In place of the previous points system with an assessment of offenses of 1 to 7 points, the driving fitness rating system was established with new ratings. According to this, the registered offenses or misdemeanors are divided into the following categories depending on their importance for traffic safety (§ 4 (2) Road Traffic Act (StVG)):
3 points: Offenses related to traffic safety or equivalent offenses if the driving license has been withdrawn or if a lock-up period has been granted for the issue of a driving license
2 points: Offenses related to traffic safety or equivalent offenses without removal of the driving license or without a waiting period for the issue of a driving license; particularly traffic safety impairing or equivalent offenses
Similar to the visual acuity of the eye, rating systems also recognize patterns and contours with different accuracy.
You may have already experienced it with your ophthalmologist: An “8” is considered a “B”, a “c” is confused with an “e”, and so on. The resolution of the eyes is different. The same is true of rating models and methods of classifying the creditworthiness of economic units. Each rating also has the dimension of different evidence.
Maybe your rating was just turned on the wheel of fortune? It may happen to some debtors or disappointed investors. If there is no correlation at all between the rating given and the actual probability of default, the evidence of the rating would be zero, 0%. Only theoretically can the evidence reach 100% absolute judgmental certainty. An unplayed dice or a state-controlled, notarized lottery game gives examples of probability judgments that can be given with almost absolute certainty.
Another example: Your good gut feeling may allow you to assess tomorrow’s weather conditions. The evidence is low, but maybe you’re lucky and in line with your prognosis. However, the German Weather Service works according to the DWD law with more extensive resources and far-reaching responsibility for the meteorological security of maritime and aviation and official warning. Scientifically, these forecasts are based on higher evidence. What applies to the weather forecast applies in this sense for any kind of rating result. If you do not even use the thermometer and the barometer for the prediction, you often miss the prognosis.
Another example: An unzinked die rolls a one with a one-sixth chance. Thus, a rating system that assigns to this event exactly this probability of 16.6 …% and not erroneously a higher (e.g., 20%) or lower (e.g., 10%) probability is better justified by empirical facts.
In the case of credit rating, the more highly accurate information on default risk estimates can be made available, the more likely it is to provide a high quality, accurate rating. Numerous sources of information help to find a high-evidence rating. The rated company itself can play a key role in determining an accurate rating by providing you with well-known credit rating information and by explaining the extent of its involvement in the judgment of these institutions.