Understanding credit ratings and ESG factors

Risks affecting fixed income instruments include market, liquidity and interest rate risks (and these may interplay with non-linear effects).

Rating agencies take various approaches – based on definitions, methodologies and time horizons – when assessing credit risk. Broadly speaking, credit risk is the risk that an issuer does not make a timely repayment as promised: it depends on its ability to repay its obligation (and therefore generate cash flow) but also on its willingness to meet its financial commitments when due.

Ratings are calculated based on a range of factors used by credit rating agencies (CRAs) to form an opinion on the overall creditworthiness of an issuer (or with respect to a specific issue). Some of these factors are difficult to identify and quantify; some inevitably depend on a degree of subjectivity in the development of the methodology framework; some information is publicly available and some may only be disclosed to CRA analysts.

Some ratings may also try to capture the expected financial loss suffered in the event of default. The diagram below illustrates how the expected loss may be calculated (although, as previously highlighted, methodologies vary). ESG risks may not only affect the probability of default but also the estimated financial loss an investor may incur as a result.

When assessing credit risk, CRAs do not attempt to capture the environmental impact of a bond issue/issuer, nor its ethical or social impact. For example, they do not focus on measuring the environmental damage in terms of the CO₂ emissions of a company that is a heavy polluter, or the environmental benefit of a company that avoids them. Rather, when analysing a heavy polluting company, they would focus on any material impact – including financial, regulatory and legal factors – that could affect the company’s credit profile. CRAs may also assess the level and predictability of an issuer’s ability to generate future cash to honour its commitments to debt holders. To this end, they would also take into account its assets and how easily it would be for an issuer to sell them to repay its debt obligations. This could be problematic in the case of stranded assets, for instance.

On the quantitative side, CRA analysis focuses on the issuer’s overall financial viability, the strength of its balance sheet, and how it compares to other issuers. For example, using standard credit ratio analysis, CRAs may test: how ESG factors affect an issuer’s ability to convert assets into cash (profitability and cash flow analysis); the impact that changing yields – due to an ESG event – may have on the cost of capital, depending on the share of debt used in the issuer’s capital structure (interest coverage ratio and capital structure analysis); the extent to which ESG-related costs dent the ability of an issuer to generate profits and add to refinancing risks; and how well an issuer’s management uses the assets under its control to generate sales and profit (efficiency ratios).

The qualitative side complements the quantitative side by adding information that analysts gather from sources including interviews with management, third-parties or the press. Since many ESG factors are intangible, this part of the assessment helps CRAs highlight which companies, despite poor short-term performance, have the potential to recover and prosper in the long-term, and vice versa.

Ultimately, CRAs are tackling this question: What is the level of risk associated with receiving full and timely payment of principal and interest on a specific debt obligation, and how does that risk compare with that of all other debt obligations?

When it comes to ESG factors, those that can impact credit risk need to be separated from those that may have an impact on the financial performance of an issuer without increasing the relative likelihood of default. For example, a hurricane may leave a company out of business, hit revenues only temporarily or even boost them over the long-term if new investments replace outdated capital goods. The consequences depend on the financial strength of the borrower, its ability to absorb higher costs and market supply/demand conditions.

Weak management of ESG risks may cause a company reputational damage, affect its ability to raise funding (debt and equity) and, more broadly, negatively impact its financial performance. In contrast, sound ESG practices may bolster the company’s reputation, as well as facilitate access to markets, improve financial performance and appeal to a wider investor base.

The ESG in Credit Ratings Initiative receives financial support from The Rockefeller Foundation