Understanding Credit Quality

serenemaklong.blogspot.com

SIMPLY put, credit quality is indicated by the amount of debt the company owes, versus equity or total assets. Those who want to invest in equities or bonds can look at the relevant company’s credit quality.

For bonds, rankings by rating agencies such as AAA, AA and A, give a quick indication of their quality. It can be used to estimate the likelihood of getting your capital back.

For equity holders, if a company has trouble servicing its debt, it is usually a sign of financial mismanagement and its cash flow is insufficient. That affects the company’s valuation and dividends.

Rating agencies often rely on both financial ratios and qualitative analysis to conclude their credit ratings. But there are blind spots – things that are difficult to detect – in this process. Blind spots are usually in the areas of corporate governance, management quality, market rumours in blogs, management reputation and demographic inclinations. If you know the temperament of the family that runs the business, you will understand the company’s ability and willingness to pay back its debts. These qualitative features are hard to measure and are often identified through interviews by fund managers and analysts with the company’s management team.

Some companies have a higher tendency to default, simply because of the nature of their business. For example, companies that depend too much on too few customers or supplies, or operate in industries that have highly volatile prices, are more susceptible to credit issues.

Credit hotspots

The oil and gas ancillary industry is currently facing credit challenges, due to an increasingly competitive business and the need for heavy capital expenditure. Similarly, some toll road companies in Malaysia, despite being a seemingly stable business, have also been affected, partly due to the greenfield nature of their projects and the difficulty in forecasting traffic volume.

Government default risk is also present. Some of the measures that investing industry looks at are the country’s fiscal deficit-to-GDP ratio, GDP growth prospects and history of default. For example, Greece has defaulted on its government debt payment obligations.

The current financial distress faced by the nation is not new. Several European countries, during their years as emerging economies, were also prone to defaults during the 1700s and 1800s. But remember that it was much easier to default on your loans a long time ago. Even the King of France had, while executing lenders, suggested the need to default every now and then, in order to cleanse the system and maintain economic equilibrium!

On a final note, depositors often take for granted that deposits will always be paid back. Fortunately in Malaysia, the existence of a limited deposit guarantee scheme (RM250,000 per depositor per member institution) provides savers with a great deal of assurance. Still, those with large deposits should pay attention to their bank’s credit ratings, and this applies to both domestic and foreign banks. With the financial uncertainties caused by the ongoing European debt crisis, it is important to take the necessary precautions with their hard-earned savings. The concepts of diversification and credit-quality assessment do apply to our fixed deposits.

(Written by Ray Choy - head of global credit research and fund manager of AmInvestment