Investors do not anticipate the proposed Standard & Poor's ratings changes will cause the uproar that the changes Moody's Investors Service proposed earlier this year did, but the topic is getting its fair share of water cooler time at investment firms. "We are talking about it here, but I'm not sure [what the effect will be]," said one investor.
Last Wednesday S&P announced its proposal to modify its current recovery ratings practice. The new ratings will reflect a revised notching framework; raising or lowering a specific issue rating from that of its issuer credit rating. It will also extend recovery ratings coverage to speculative-grade unsecured debt for industrials and to speculative-grade secured and unsecured debt for financial services companies and non-U.S. public finance entities. In the past it only provided recovery ratings for secured debt on a 1+ to 5 scale.
Investors view S&P's new methodology as a modification to an existing system, whereas Moody's introduced all new methodology and ratings. "It's not a completely new approach like Moody's, they are just tweaking [their methodology]," one portfolio manager said. "I don't anticipate any problems. My initial read is, it's a pretty mild [change]. I don't think they are looking to rock the boat. Frankly, I think they saw the turmoil Moody's caused and didn't want to do that and are trying to be more user-friendly." Another investor agreed that S&P is just modifying its recovery rating systems, while Moody's added new ratings.
Now S&P will introduce a seven-point scale (1+ to 6) in place of the current six-point scale (1+ to 5). The notching framework would keep issue level ratings closer to the issuer credit ratings, than an expected loss framework. It anticipates that debt issues with a 1 or 2 recovery rating would be upgraded by one notch; that is about 45% of its 1,600 issues. Also, a portion of secured debt with a 5 recovery rating could be downgraded.
Laura Feinland Katz, managing director, explained that the scale was increased to accommodate the number of unsecured and subordinated debt issues that will fall at the lower end. "When adding unsecured and subordinated debt, we will have a lot more fours, fives and sixes, and to continue to show proper differentiation we are rebasing the way we do notching," she said.
S&P said it does not anticipate the extension of recovery analysis to unsecured debt and the revised notching framework to directly impact collateralized debt obligation methodology or CDO ratings.
The ratings agency is accepting feedback until Dec. 1 and then for the following two months, will meet with various market participants and review comments received by email. At that time it will publish a final methodology, which it would hope to begin implementing by the end of the year. The rollout would begin with secured industrial debt issues, where recovery ratings have been used, then rollout unsecured industrial ratings, etc. The plan is to roll out the ratings by sector and region over 12-18 months.
Last January Moody's told the market it planned to introduce both loss-given-default ratings and probability-of-default ratings (CIN 1/16) that would increase loan ratings by one or two notches. It did not previously offer a type of recovery rating. Investors were, and some continue to be, worried that the increased ratings could lead to repricings, which would hurt collateralized loan obligations (4/17). Moody's began rolling out the new ratings in September (9/22).
"I think they are fine tuning their scheme, but at the end of the day, my read is, it is consistent and reinforces the message of recovery rates," the portfolio manager said.