Real-Time Ratings Are More Dynamic than Fitch’s
Markets are forward-looking and the concerns that played into Fitch’s decision are not new information to most investors.
KEY TAKEAWAYS
US debt markets seemed to barely react when Fitch downgraded US government debt.
Markets are forward-looking and often ratings changes reflect information that is already reflected in market prices.
Combining market-based data with stated credit ratings from NRSROs may form a more complete and real-time assessment of credit quality.
On August 1, Fitch Ratings downgraded the US government’s credit rating to AA+ from AAA (the best possible rating on a scale from AAA to D).1 Fitch is one of several nationally recognized statistical ratings organizations (NRSROs), along with Standard & Poor’s (S&P) and Moody’s, that publish credit ratings on a wide range of bonds from issuers such as governments and corporations.
In commentary supporting the ratings downgrade, Fitch pointed to several factors, including the debt ceiling debate earlier this year, growing US government debt, and governance concerns.2 Yet in the days immediately following the ratings change announcement, the spread for credit default swaps (CDS) on five-year US Treasuries, which reflects the cost to insure against the US defaulting on its sovereign debt, barely moved (see Exhibit 1). After all, the fiscal and political state of the US government is not exactly a state secret, and while each credit rating agency uses its own methods to assess and issue ratings, they have access to the same historical data and observations that the rest of the market has. Markets are forward-looking and the concerns that played into Fitch’s decision are not new information to most investors.
Exhibit 1
Muted Market Reaction
Credit default swap spreads for five-year US Treasuries
Source: Bloomberg.
To assign credit ratings, NRSROs use rating methodologies and analyze market information and issuers’ business or sovereign risk profiles, often relying on information from prior financial statements and forecasts. NRSROs’ ratings process can create a lag between when the market prices in an issuer’s credit change and when an NRSRO changes an issuer’s stated credit rating.
We believe market prices, unlike NRSROs’ ratings, provide a real-time assessment of how market participants view the credit quality of fixed-income securities. That’s because participants—and prices—are able to immediately respond to all available information. While stated credit ratings can be informative when assessing an issuer’s creditworthiness, we believe relying on stated ratings alone can lead to using stale credit information. Because of this, Dimensional combines market-based data with stated credit ratings from NRSROs to form a more complete and real-time assessment of an issuer’s credit quality.
To assess whether a bond is trading at a market price that is significantly different from those of its peers with similar stated credit ratings, Dimensional uses, among other things, price information from the Trade Reporting and Compliance Engine (TRACE). If prices in TRACE imply a lower credit quality than the bond’s stated credit rating, Dimensional may assign that bond a lower internal rating.
With a process that monitors live prices, Dimensional can identify bond issuers that may no longer fit within a fixed-income strategy’s credit guidelines and potentially avoid such issuers. For instance, as market-based credit information changes, Dimensional uses this information to assign each bond issuer a Dimensional credit rating. In contrast, index-based fixed-income funds rely on a third-party index to determine eligible issuers. As a result, index funds rely on NRSRO ratings to identify which bonds meet their minimum required credit rating for eligibility in the fund. However, Dimensional’s daily credit monitoring enables portfolio managers to use live market prices to assess an issuer’s credit rating rather than rely on lagged NRSRO research.
Even for investors focused on the investment-grade-rated segments of global bond markets, market-informed credit ratings and NRSRO ratings can occasionally differ materially. Between 2010 and 2022, Dimensional downgraded 193 bonds from investment-grade-rated bonds to high-yield-rated, as Exhibit 2 shows. Downgrades from investment grade to high yield are often referred to as “fallen angels.” Of 193 fallen angels identified by Dimensional, 86% were based on Dimensional’s market-based credit monitoring process, whereas only 14% were in reaction to an NRSRO downgrade. The ability to proactively identify issuers whose bonds are trading like lower-rated bonds may enable Dimensional to reduce credit risk in real-time more effectively.
Exhibit 2
Not Falling for Fallen Angels
Internal downgrades from investment grade to high yield, 2010–2022
Source: TRACE. Dimensional eligible universe data as of December 2022: ~21,000 securities, ~1,900 issuers, of which ~5,000 securities and ~750 issuers were held globally. Holdings are subject to change.
Fixed-income credit ratings may assist investors in understanding the creditworthiness of different bond issuers. However, Fitch’s recent downgrade of the US government credit rating reinforces that NRSROs’ credit rating changes generally do not provide markets with new information. Rather, NRSROs’ rating changes seem to reflect information already incorporated in market prices. By using live market prices, Dimensional has designed a credit monitoring process that can help us stay one step ahead of NRSROs when assessing issuers’ creditworthiness.
FOOTNOTES
1. “Fitch Downgrades the United States’ Long-Term Ratings to ‘AA+’ from ‘AAA’; Outlook Stable,” Fitch Ratings, August 1, 2023. Rating agencies like Fitch Ratings and Standard & Poor’s Corporation (S&P) rate the credit quality of debt issues. The Fitch scale is from AAA to D with intermediate ratings of (+) or (-) offered at each level between AA and CCC.