A few facts on credit ratings

The hot topic on the minds and lips of most Barbadians and those throughout the region, has been the recent economic challenges faced by Barbados. Particularly, the recent credit rating downgrades that the country’s economy has experienced.

News outlets, pundits and social media all declare the dire straits that the downgrades signal, but what exactly is a ‘downgrade’? What does it mean? Why is it such a big deal? Let’s examine some frequently asked questions around credit ratings and downgrades so that we can gain a much better sense of where our country is perceived to stand economically; and what that means for us.

What is a ratings agency? Ratings agencies specialize in the assessment, analysis, reporting and monitoring of factors and trends that affect creditworthiness (ability to pay debts) of businesses and countries. They also assess specific financial instruments being issued, e.g. a bond being sold to the public by a bank.The three major credit ratings agencies are Standard & Poor’s, Moody’s and Fitch.

What is a credit rating? A credit rating is an opinion about credit risk. Credit risk is the risk that a business or company would not be willing or able to meet its debt obligations in full or on time. The ratings can also apply to individual debt issues and the likelihood of that issue defaulting or not being able to be repaid as agreed upon.

Why should I trust them? Each of the ratings agencies uses its own approach to calculate ratings and also have their own ratings scales. They tend to be transparent about the methods and scales, providing explanations on issued ratings as well as outlook rationales. However, it is important to remember that the agencies are by no means perfect. Credit ratings are not an exact measure of the likelihood of default and are not guarantees of credit quality. The credit agencies have gotten some big ratings wrong. One example is the assignment of high quality ratings to the instruments that eventually caused the credit crisis of 2008. It is also important to note that the entities that they assess pay for the assessment so there is sometimes the perception of bias. Therefore, while they are useful, one should not rely solely on them when making decisions.

Who uses them? Credit ratings are mainly used in two ways. They are used by investors as screening tools when making decisions on where to invest. Credit ratings are also used by companies and countries when seeking to borrow. They use them as a signal of their willingness and ability to repay their debt obligations; the better the rating, the more attractive the debt may be to lenders.

What happens in a credit rating downgrade? A rating downgrade is a negative change in the rating of a security, business or country. This situation occurs when the analysts of the ratings agency believe that future prospects for the security or entity have weakened from the original recommendation, impacting the perceived or actual ability to repay debt in full or on time. This is usually due to a material and fundamental change in the issuer or business’ operations, future outlook or industry; in terms of a country, the future outlook or economic landscape.This negative change in credit rating often acts as a signal to lenders, who would demand more compensation (a higher interest rate) for the additional perceived risk they are taking.

Once downgraded, can upgrades occur? Upgrades can and do occur. An upgrade is usually triggered by a steady and sustained improvement in the fundamentals and financials of the entity that is being assessed or of the issuer of the security being analyzed. For countries, upgrades have come after economic reform, or country leadership communicating or demonstrating actionable plans for economic recovery. For example, in May of 2015, Moody’s upgraded Jamaica based on improving economic indicators and demonstrated commitment to structural reforms.

Credit Ratings and Barbados? Barbados has experienced eight Standard & Poor’s downgrades over the past 14 years and seven Moody’s downgrades over the same period. On the Standard & Poor’s credit rating scale, Barbados holds a rating of CCC+; and on Moody’s scale, a rating of Caa3. Both these ratings are in the speculative area on their respective scales. In general terms, this means that Barbados is seen as vulnerable to nonpayment of its debt obligations.

The downgrades have had a prolonged negative impact on the economy. Negative credit rating movement makes Barbados increasingly unattractive to potential lenders and, when lending is offered, it will be increasingly expensive and burdensome. This has a negative impact on the country’s foreign currency reserves, as the debt will be repaid in foreign currencies; mainly US dollars. These reserves are also used to purchase other necessities for the function of the country so the effect of their reduction can and will be widely felt.

As demonstrated elsewhere, upgrades do occur, but it will take a combination of creative thinking, strong leadership and smart decision making to achieve it. Hopefully we will see Barbados beginning its climb back up the credit quality ladder soon.

 (Michael Jordan is a financial professional)

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