This is the third part of our in-depth look at the components of our proprietary FRISK® score, a dynamic, mathematically-driven solution which has proven 96% accurate in predicting U.S. public company bankruptcy risk during a 12-month period. Click on the links to read Part 1: The Wisdom of the Markets and Part 2: Financial Ratios.
To achieve 96% accuracy in predicting bankruptcy risk, the FRISK® score incorporates three commonly used risk tools and one proprietary measure into a single, easy-to-use metric. By bringing these varied tools together, the FRISK® score is capable of providing more insight than any single measure would alone.
For example, a Merton Model, based on stock market capitalization, is inherently volatile. A second indicator, financial ratios - like those included in the Z"-Score - are only available once a fiscal quarter. When the two are blended together, however, the result is a more accurate picture of a public company's risk.
The FRISK® score doesn’t rely solely upon these two metrics to assess a company’s financial health - it includes two additional components to further strengthen the finished product: bond agency ratings and CreditRiskMonitor subscriber usage data (crowdsourcing). This article will take a look at bond agency ratings, which offer up a unique, often overlooked, advantage when it comes to assessing public company bankruptcy risk.
Bond Agency Ratings: An Insightful Tortoise
One of the biggest criticisms of agency ratings – Fitch and Moody’s among the most recognizable - is that they are slow to reflect the financial health of a company if it is deteriorating. To a point, this is a valid criticism: bond agencies are extremely careful in their assertions, using committees to verify and assess information. That can be a time-consuming process, delaying the implementation of rating changes.
Yet this level of caution isn't the only reason why ratings are slow to change. Two of the largest entities which rely upon bond ratings are pension funds and insurance companies. Quick, short-term rating fluctuations aren't desirable for these customers as they often follow stringent investment rules, looking to their investments to cover very long-term liabilities. It is far more desirable for these customers to deal with changes only when there is a material, long-term risk, or improvement, being integrated into the bond rating.
Why We Use These Ratings Even Though They Don’t Relate to Bankruptcy
As we just stated, rating agency ratings are slow-moving by design. Another point of interest is that the companies that make use of bond agency ratings are concerned with default risk, not bankruptcy risk. Investors are more concerned with default because of its direct correlation with a company’s ability to make good on their bond.
Intuitively, though, an increase in default risk means an increase in bankruptcy risk - which is why bond agency ratings play an important part in the FRISK® score. Although they are slow-moving, changes in a rating are supported with years – sometimes decades – of analysis. They’re well-reasoned and are generally an accurate reflection of long-term issues. When integrated with the faster-moving metrics in the FRISK® score, slow bond rating changes help to improve the accuracy of CreditRiskMonitor's proprietary risk measure.
The Pros and Cons
One of the key reasons that bond agency ratings are so valuable is that these entities have access to financial information that is not public. In an effort to ensure agency ratings are as accurate - and positive - as possible, companies being rated will typically release information to the agencies that they wouldn't release publicly. That can include a vast array of documents, such as business plans and detailed specifics of financing tactics.
This fact, along with the slow and deliberate nature of the rating process, means that there is deep insight provided by agency ratings. That's a key benefit, but "sticky" ratings are a notable problem when financial distress materializes quickly. The FRISK® score augments the ratings’ effectiveness by including faster moving metrics like stock market data, which can be driven by emotion and not fact. In this case, the slow and deliberate information provided by agency ratings offsets the weaknesses of fast-moving market information, and vice versa.
Also crucial: not all public companies have agency ratings. You can't rely on bond ratings alone, and this is why the FRISK® score is designed to provide accurate findings even when no ratings are present. However, when available, agency ratings add valuable insight to the score and let you focus your precious time and attention on the most pressing financial risks.