Currently there is almost no “income” in fixed-income investing. In preceding decades interest rates took on the job of compensating investors for the credit risks they bear. But with no cash to compensate risks, analytical scrutiny of issuer creditworthiness has dramatically increased. Yet this scrutiny is happening in a kind of analytical vacuum as confidence in credit-rating agencies is near an all-time low.

In fact, the Dodd-Frank Wall Street Reform and Consumer Protection Act requires regulators completely strike from their regulations the use of credit ratings. Essentially, doubts about the credit ratings agencies are now formalized. Doubts about credit-rating agencies primarily arose due to numerous conflicts of interest and the backward-looking nature of the analytical process, which seemed to predict nothing.

In this environment of high demand for — but low supply of — credit ratings alternatives, an overview is necessary. Alternatives tend to fall into four categories:

• The scenario planning method
• Market-based measures
• Fundamental analysis of credit issuers and issues
• Third-party assessments

The Scenario Planning Method

Perhaps most radical of the current options is that suggested by a new boutique financial advisory and risk management firm, Invictus Group. (See the full interview with Invictus Group founder Kamal Mustafa for an engaging discussion about the state of the financial world and how Invictus is trying to help improve it.) Invictus offers a massive data-driven scenario planning alternative to credit ratings in their ICAM product. In fact, this methodology is strongly in accord with the U.S. Federal Reserve Board’s stress test, 2012 Comprehensive Capital Analysis and Review (CCAR).

The firm diligently worked with financial institutions and regulators to collect data about every single asset on U.S. financial institutions’ balance sheets. With that micro-level data in hand, they conduct rigorous stress tests to assess institutions’ overall credit risk, over numerous time periods.

This solution is forward-looking and evaluates how financial institutions’ portfolios change over time. This approach takes much of the guess work out of credit analysis. Further, because Invictus has worked with regulators in crafting their ICAM product, there currently appear to be no conflict-of-interest issues.

Market-Based Measures

It is possible to evaluate issuer creditworthiness from simple, publicly available market data. Regulators are strongly considering this alternative approach to credit ratings. For example, many are considering looking at a credit issue or issuer based on the following criteria:

• Leverage, or: total liabilities ÷ market value of assets.
• Cash flow, or: EBITDA ÷ market value of assets.
• Volatility, or: the standard deviation, σ, of an obligor’s stock price.

But it isn’t just regulators that are using market-based measures. In a recent academic working paper, tilted “Credit Ratings and Credit Risk,” Brandeis University’s Jens Hilscher and Oxford University’s Mungo Wilson demonstrate that credit ratings by Standard & Poor’s dating back to 1986 are outperformed by a simple model in predicting corporate failure.

Components of the model measure profitability, leverage, past returns, volatility of past returns, firm size, firm cash holdings, and firm valuation. This approach has the benefit that each of these measures is readily available and easily calculated. In addition, it is demonstrably superior to credit-agency ratings in predicting default.

Another market-based measure under consideration is to look at sovereign credit default swap (CDS) spreads. Unfortunately, a recent Wall Street Journal article based on proprietary research indicated that CDS markets are thinly traded and therefore may not be the best indicators of actual default risk.

Yet another market-based measure is to compare the size of issuer bond spreads to the yields of some objective market index, such as the Markit CDX series of indices. The larger the spread, the higher the risk weightings assigned to the debt.

Each of the above market-based measures has the advantage of being objective, forward-looking, and allowing for specific risk weightings to be assigned to a given asset. However, disadvantages include the volatility of market-based spreads and the fact that markets often misprice debt; witness the pricing of subprime mortgages in the lead up to the Great Recession.

Fundamental Analysis of Credit Issuers and Issues

Traditional credit analysis work done by prospective buyers of debt is an alternative to credit ratings as well. In fact, there was a time in the not-too-distant past when buyers of credit actually did their own homework rather than relying solely upon a third party to provide a rating of a debt issue for them. However, that was before the massive and unprecedented increase in debt issuance of the last several decades made thorough analysis of each issue more difficult.

While doing analysis the old-fashioned way remains an alternative, it may not be nimble enough for high-volume debt buyers. Furthermore, because these methods rely on historical data, they are not specifically forward looking.

Third-Party Assessments

Another alternative is the continued use of a third party to evaluate credit risk. Specifically, U.S. regulators are considering using the Organisation for Economic Co-operation and Development (OECD) and its Country Risk Classifications as a basis for new risk-based capital requirements for financial institutions. A potential problem with this approach is that the OECD does not evaluate the creditworthiness of corporations, just of sovereigns; thus, orphaning corporate, municipal, and structured product credit buyers.

An additional problem is that this approach is unlikely to address credit-ratings critics’ biggest concerns named above. By simply replacing a set of third parties (i.e., Moody’s, S&P, Fitch, et al.) with another third party (OECD), the vulnerabilities in the credit-ratings process are likely to remain.

On the commercial side, corporate security firm Kroll has recently started a new business named Kroll Bond Ratings. Kroll is 40% owned by pension funds and foundations, and it is hoped that the inclusion of bond buyers in the ownership structure will overcome the conflicts of interest that are suspected to have plagued the old line Nationally Recognized Statistical Rating Organizations (NRSRO).

Conclusion

It may seem valuable to debate the merits of alternatives to credit ratings to uncover the One, Superior Method. However, in a post–Great Recession era in which emphasis seems rightfully placed on the “risk” end of the “return versus risk” continuum, and in an era of high-performance computing and large research budgets, perhaps the best method for evaluating default risk is an amalgamation of the above methods. These methods, combined with a sense of personal analytical responsibility are a potent mix.

Originally published on CFA Institute’s  Enterprising Investor.