Morningstar Advisor - February/March 2011 - (Page 65)

Another Vote for Market-Based Measures By Haywood Kelly How Morningstar uses market prices in its corporate credit ratings. When we developed the Morningstar Credit Rating for corporate issues in 2009, we had two goals in mind: be forward-looking and be timely. No one needed yet another rearview mirror assessment of financial health. To make our ratings forward-looking, we used measures like our economic moat rating and our analysts’ forecasts of cash flows during the next five years. To help ensure timeliness, we embedded a market-based measure of financial health—Distance to Default. As William Mast argues in “Redefining Credit Risk,” (Page 64) with regard to credit default swaps, markets are often a leading indicator of financial distress. In many cases, market prices will reflect deterioration in a company’s credit strength well before they show up in financial statements, analyst forecasts, or traditional credit ratings from the likes of S&P and Moody’s. Based on our own backtesting, as well as a cottage industry of academic work, Distance to Default has proved a valuable early indicator of financial distress because it takes real-time market signals as inputs. Take Ambac, the only company with a Morningstar credit rating that defaulted in 2010. (We initiated coverage with a C rating in September.) The graph shows the deterioration of Ambac’s Distance-to-Default score during its path toward bankruptcy. In February 2008, the probability of default for this insurer jumped to more than 55% from 17%, signaling severe financial distress. By contrast, it took S&P until June 2009 to cut its issuer rating on Ambac to below investment grade. Moody’s was a bit quicker, cutting its Ambac issuer rating to below investment grade in November 2008. Ambac Financial Group Distance to and Probability of Default Distance to and Probability of Default Probability of Default Distance to Default 1.50 1.00 0.50 0.00 –0.50 –1.00 –1.50 –2.00 02/08 06/08 10/08 02/09 06/09 10/09 02/10 06/10 The market inputs fed into our Distance to Default algorithm are not CDS prices, but equity prices. For a debtholder, the equity of a company represents the cushion below you in the capital structure; as long as the equity has value, so do your bonds. The absolute level of the share price and the historical volatility of those share prices feed into the Distance-toDefault algorithm. As a company’s share price 12/07 12/08 falls, so does its Distance-to-Default score; likewise, the more volatile the company’s stock, the worse the score. As a firm’s equity cushion shrinks, or when there’s great uncertainty as to the value of that equity cushion, the bonds become more risky. A practical advantage to using equity prices as our market-based indicator is that equity markets are extremely liquid, more so than the CDS market. Unless there is demand for the CDS of a particular issuer, a price won’t be available. In the high-yield space, CDS availability is particularly spotty, and with one fourth of our credit-coverage universe rated BB or less, using CDS simply isn’t an option. So, while CDS prices are extremely useful indicators when prices are liquid and available, they don’t provide (yet, anyway) broad enough coverage for use in Morningstar’s corporate credit ratings. Why not use bond prices, you ask? Our analysts 12/09 also keep tabs on the price movements of the bonds of companies they follow, but we run into liquidity problems. A significant portion of corporate bonds sit snug on the balance sheets of insurance companies, pension funds, and other long-term institutional owners. Some bonds may not trade for months at a time, sapping any reported prices of their informational content. Equity prices are, again, a better all-purpose indicator of market sentiment. Haywood Kelly, CFA, is vice president of equity research at Morningstar. MorningstarAdvisor.com 65 http://www.MorningstarAdvisor.com

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

Morningstar Advisor - February/March 2011
Contents
Contributors
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