Morningstar Advisor - February/March 2011 - (Page 62)

Gray Matters Redefining Credit Risk By William Mast The credit-default-swap market may provide a viable alternative to credit-rating agencies. For more than a century, the big three bond-rating agencies—Moody’s, Standard & Poor’s, and Fitch—have been the unchallenged arbiters of corporate creditworthiness. Rating references are embedded in hundreds of guidelines, laws, and private contracts that affect a broad range of financial concerns. The financial crisis, however, laid bare a weakness in the credit-rating agencies’ models: Their ratings are backward-looking because they are predicated on historical data that is observed at a discrete point in time. Given this constraint, the agencies have not been favorably positioned to react quickly to rapid changes in a creditor’s financial health. Hence, evidence of accounting fraud in a company’s financial statements may elude their scrutiny. Also, the agencies have demonstrated that they remain ill-equipped to assess the risks of some complex, structured products. There is now considerable momentum in the markets and on legislative agendas to explore alternative ways to assess the credit ratings of public companies. Independent credit research efforts—some housed under the same roof as the big three—have already broken the issuer-paid model and are using real-time market factors in their evaluations. In fact, recent research points to the credit-default-swap market as a source for a more fluid, market-driven metric to gauge the creditworthiness of an issuer. Market Indexes and Ratings The disconnect between the credit-ratings agencies and the market’s risk perception is illustrated in the exhibit, which plots individual 62 Morningstar Advisor February/March 2011

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2011

Morningstar Advisor - February/March 2011
Letter From the Editor
First, Do No Harm
Do You Use Active or Passive Investment Strategies?
Best of Both Worlds
How to Build an Index
Accountable Investor
Nice Guys Finish First
Four Picks for the Present
Investment Briefs
A New Guardrail Against Risk
Tech Loosens the Purse Strings (a Bit)
It’s More About Costs Than Active or Passive
Play Your Stars
In Between Active and Passive
Selling Beta as Alpha
The Weighting Game, and Other Puzzles of Indexing
Leaving the Nest
Redefining Credit Risk
Another Vote for Market-Based Credit-Risk Measures
Big Opportunities in Small-Cap Stocks
Benchmarks? What Benchmarks?
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Slide, but Assets on the Rise
Indexing’s Lunatic Fringe

Morningstar Advisor - February/March 2011