Capital Markets

S&P on Junk: The Future Is Now

The ratings agency changes its speculative-grade ratings method, focusing on risks in play over a two-year time horizon.
David McCannMay 13, 2008

Standard & Poor’s announced Tuesday that it is changing its approach to rating speculative-grade credit by placing more emphasis on near-term risk factors.

The new practice for rating so-called “junk” securities — rated BB or lower — places greater emphasis on expected risk over a two-year period. And S&P now will emphasize a one-year horizon in determining speculative-grade ratings outlooks, which indicate the likelihood for rating changes.

S&P formerly focused risk factors in play over three to five years, for both speculative-grade and investment grade credit.

In a report released Tuesday, S&P said the move was prompted by “the market’s increasing willingness to accept riskier credits in recent years.” However, that has been a long-term evolutionary process. In its report the firm chose to compare the percentage of below-investment-grade industrial ratings today, 72 percent, with that of 27 years ago, when it stood at 32 percent.

In a subsequently issued FAQ sheet, S&P, which has come under heavy fire recently for some of its ratings methodologies, gave this answer to the question of why these changes are being made now: “This initiative is largely a function of our ongoing efforts to improve our products and keep them current with market developments. We think of these changes as evolutionary, building on past enhancements. We should also be better positioned to confront the current credit environment and its challenges — even if the timing is coincidental.”

In general, the shift to a shorter time horizon for evaluating risk recognizes that investors take a more near-term approach when it comes to leveraged investments. “For speculative-grade companies, change is the rule,” S&P wrote.

“For example, massive debt maturities in the next 12 to 18 months are much more relevant than business risk concerns a company may have to deal with four or five years from now,” the ratings firm said. “The refinancing requirement creates a near-term risk with a relatively high level of occurrence, especially for a speculative-grade company.”

To help with its revised focus, S&P said it created a new risk matrix to evaluate the probability, impact, and time frame of a company’s risks and opportunities. “For example, technology companies are generally associated with higher levels of business risk; so are companies of small size,” the firm wrote. “However, the business dynamics of a particular niche may argue for placing less emphasis on the general risk profile.”

The analytical enhancements are not designed to affect the ratings distribution, according to Standard & Poor’s. “On the other hand,” it added, “we cannot predict that the overall impact will be neutral, particularly given the current backdrop of economic and credit-market challenges.”

S&P also plans to “bolster transparency by including in our published reports a more detailed discussion of alternative scenarios that could cause a transition in a rating or outlook, as well as a higher level of specificity when discussing covenant compliance and headroom.”

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