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Our Credit Ratings Methodology

Dec. 17, 2020 9:05 AM ET
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David Trainer's Blog
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More reliable & proprietary fundamental data, proven in The Journal of Financial Economics, drives our Credit Ratings and research, which offer unique insights into the creditworthiness of companies.

We assign one of five Overall Credit Ratings to 2,750+ companies: Very Attractive (best rating), Attractive, Neutral, Unattractive, Very Unattractive (worst rating). We use the same five-point rating system for Equities and ETFs & Mutual Funds.

The Overall Credit Ratings are based on our ratings for five fixed income ratios. We use a 1 to 5 rating scale for each ratio, with 1 as the best (Very Attractive) and 5 as the worst (Very Unattractive). The Overall Credit rating equals the average of the individual ratio ratings rounded to the nearest whole number. See Figure 1 for a template of the Credit Rating table and how we score each ratio.

Figure 1: Credit Ratings Table and Rating Scale

Sources: New Constructs, LLC

In general, our Overall Credit Rating methodology assumes companies are more credit worthy when:

  1. Leverage is lower as measured by:
    1. Debt to Capital measures how much debt a company has relative to its Total Capital.
  2. Liquidity is higher as measured by:
    1. EBITDA to Debt measures the amount of income available to pay down debt.
    2. Free Cash Flow (3-yr Avg.) to Debt measures the amount of cash flow a company generates to cover its interest-bearing debt.
  3. Coverage is higher as measured by:
    1. Cash to Debt measures how much cash a company has on its balance sheet relative to its debt obligations.
    2. Interest Coverage measures the company’s ability to meet its interest payments with its current operating profit.

Note that we calculate these ratios using our Adjusted Fundamentals instead of unscrubbed accounting data. Therefore, our credit ratings will often be quite different than ratings from traditional credit rating firms.

How We Determined the Distribution of Credit Ratings

When determining our credit ratings, we aimed to match the general ratings distribution by total debt of the legacy rating agencies. Specifically, we set the thresholds[1] for each ratio to result in a distribution of ratings that closely matches the distribution of ratings by legacy providers based on traditional, unadjusted debt as a percentage of total unadjusted debt. See Figure 2 for details.

Figure 2: Distribution of Ratings for Legacy Rating Agencies

Sources: New Constructs, LLC

It is important to note that we use unscrubbed accounting data in the calculation of the ratios when setting the thresholds.

Our Ratings Are Based on our Superior Data

To provide a more accurate[2] measure of a firm’s creditworthiness, we calculate the ratings for each ratio based on our proprietary adjusted fundamental data. We use our adjusted data because unscrubbed accounting data fails to account for material items hidden in the footnotes of financial filings – as proven by a paper forthcoming in The Journal of Financial Economics.

In other words, we determine the company Credit Ratings based on ratios using adjusted data while the thresholds for scoring each ratio were set based on unadjusted data.

As a result, our credit ratings more accurately reflect a firm’s true fundamentals relative to its true debt load. Differences in our ratings and rating distribution compared to legacy providers are largely due to the differences in our adjusted fundamental data and the data used by legacy rating agencies.

Figure 3: Our Distribution of Ratings Based on Adjusted Fundamental Data – as of 2/16/21

Sources: New Constructs, LLC

Thresholds Differ by Credit Rating Group

The thresholds for the ratios that drive Overall Credit Ratings are different for certain groups of companies, which we call Credit Rating Groups. We created these groups to account for the differences between sectors and different sized companies.

Different sectors have vastly different capital structures and business models that impact the ratios used to determine our Overall Credit Rating. For example, Energy sector firms tend to be highly capital intensive and rarely generate free cash flow at the levels of less capital-intensive sectors, such as Technology or Financials. To account for these and other secular differences, the thresholds for ratios are different for these sectors: Energy, Utilities, Financials, and all other sectors. These groupings make credit ratings of companies in different sectors apples-to-apples comparable.

We also created Credit Rating Groups based on market cap. Larger market cap companies tend to be less risky and can more easily handle higher debt burdens. Meanwhile, smaller market cap companies’ cash flows tend to be perceived as carrying more risk, and so, small cap companies tend to have worse credit ratings. To account for these differences, the thresholds for ratios are different for large, mid, and small cap companies.

Here’s the list of Credit Rating Groups:

  1. Energy
  2. Utilities
  3. Financials Small Cap
  4. Financials Mid Cap
  5. Financials Large Cap
  6. All Other Small Cap
  7. All Other Mid Cap
  8. All Other Large Cap

Market cap groupings are determined as follows:

  1. Small Cap < $2 billion
  2. Mid Cap >= $2 billion and < $10 billion
  3. Large Cap >= $10 billion

Figures 4-11 show the ratio thresholds for each Credit Rating Group.

Figure 4: Energy Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 5: Utilities Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 6: Financials Small Cap Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 7: Financials Mid Cap Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 8: Financials Large Cap Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 9: All Other Small Cap Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 10: All Other Mid Cap Credit Rating Group Thresholds

Sources: New Constructs, LLC

Figure 11: All Other Large Cap Credit Rating Group Thresholds

Sources: New Constructs, LLC

Overall Credit Rating Distribution

Figure 12 shows the Overall Credit Ratings distribution for 2,750+ companies split out by market cap.

Figure 12: Credit Rating by Market Cap

Sources: New Constructs, LLC

Figure 13 shows the Overall Credit Rating distribution for 2,750+ companies.

Figure 13: Credit Ratings by Rating

Sources: New Constructs, LLC

[1] Interest Coverage thresholds are adjusted to handle companies that do not report a net interest expense or whose only debt is from operating leases. In these cases, where interest is essentially null, we will automatically assign a 1 Interest Coverage rating (Very Attractive) if EBIT >=0 and a 3 Interest Coverage rating (Neutral) if EBIT < 0.

[2] Core Earnings: New Data & Evidence, a paper by professors at Harvard Business School (HBS) & MIT Sloan and recently accepted by the Journal of Financial Economics proves our data is superior to all the metrics offered by S&P Global (SPGI).

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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