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Credit Insights

Morningstar Credit Hits One Year Anniversary

Our forward-looking credit rating process sets us apart from the agencies.

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Morningstar initially launched credit ratings on 100 issuers in December 2009. Since then, our credit coverage has expanded to over 650 firms, including banks and insurers, for which we developed separate methodologies along the way.

Across our coverage universe, our fresh, unique approach has unveiled a number of bond investment opportunities and variant credit perspectives relative to the agencies. These views are backed by an issuer credit rating methodology, whose components have demonstrated a solid track record in predicting defaults during the past year.

We provide a high-level overview in this article, but click here to access our full research report, where we offer a more detailed look at some of our top bond picks, our largest issuer-rating differences versus the incumbent agencies, and more.

An Independent, Forward-looking and Transparent Rating Methodology
Morningstar's coverage universe now spans the vast majority of significant U.S. corporate bond issuers, and runs the gamut from speculative to investment grade.

Sector Issuer Ratings Investment Grade Speculative Grade Business Services 35 24 11 Consumer Goods 84 66 18 Consumer Services 69 38 31 Energy 64 43 21 Financial Services 92 82 10 Hardware 23 21 2 Health Care 77 59 18 Industrials 103 75 28 Media 28 17 11 Software 14 13 1 Telecom 26 14 12 Utilities 37 35 2 Total 652 487 165 Source: Morningstar. Data as of December 2.

Our methodology is completely independent, forward-looking, and transparent. The models that house our process are available to institutional clients, and we've made all of our issuer credit ratings and methodologies publicly available. Our process draws on the analytics of a team of 90 securities analysts, combining the business and cash-flow modeling expertise of both our equity and credit specialists. We offer institutional clients a Credit Weekly piece that updates fixed-income investors on key developments, and a Best Ideas List that highlights the most compelling bond opportunities across our universe (these items are not available through our retail subscription service). Forming the bedrock for this research, however, is our issuer credit rating methodology.

Our Process Provides a Unique and Fresh View in Evaluating Credits
Our credit rating methodology for nonfinancial companies applies to roughly 90% of our existing credit coverage universe. Below, we highlight some of the unique characteristics of each of the four pillars of this process. For a more detailed explanation of how we rate nonfinancial firms, please view our methodology document.

Business Risk

In assessing a firm's business risk, one of the key rating factors that we look at is the sustainability of a company's competitive advantages � or Economic Moat� -- a framework we have employed and honed for the last decade. The concept of an economic moat plays a vital role in our qualitative assessment of a firm's long-term cash-generating capacity. In general, we're more likely to assign investment-grade ratings to companies with moats, and more likely to assign speculative grade ratings to companies without moats. Moats also drive differences with our ratings and the agencies, as we tend to favor wide-moat issuers, and wax skeptical with regard to no-moat issuers:




 

Cash Flow Cushion�
For years, Morningstar analysts have systematically used discounted cash flow analyses to arrive at equity valuation estimates. We incorporate these granular forecasts of cash flow and the debtlike characteristics of certain cost items to arrive at our proprietary forward-looking Cash Flow Cushion�.

As a predictor of default and potential liquidity needs over a five-year horizon, the Cash Flow Cushion� stands out against traditional liquidity and coverage measures in the sense that it considers all debtlike commitments and factors in a timing element. The construction of this measure is completely transparent, and the drivers behind it are available to institutional clients in Morningstar's discounted cash-flow model.

In general, firms with higher Cash Flow Cushion� ratios score higher on our credit scale. After all, a higher ratio indicates that the firm is better positioned to meet debt and debtlike commitments with cash flow over our five-year forecast horizon. The median Cash Flow Cushion� ratio (the sum of current cash and adjusted free cash flow over the next five years divided by debtlike obligations over the same period) per credit rating bucket is shown in the bar chart below:

Solvency Score
The Solvency Score is fine-tuned to identify incidents of default at least one year in advance of such an event. Our backtesting has indicated that this measure is a better predictor of default than other widely used measures.

Though we haven't encountered an instance of default within our nonfinancial coverage universe since inception, we took a look at how the Solvency Score would have performed for a number of defaults that occurred outside our coverage universe this year. In the examples of U.S. Concrete (filed for bankruptcy protection on April 29, 2010), Radio One (ROIAK) (encountered an event of default on September 15, 2010 on its 2013 senior subordinated notes), and Blockbuster (filed for bankruptcy on September 20, 2010), the Solvency Score highlighted substantial risk nearly two years in advance. In each of these cases, the Solvency Score registered a 10 on our scale, the worst possible measure:

Distance to Default
Our Distance to Default measure is an indicator that, in part, gauges the market's perception of a firm's credit quality, and facilitates the timeliness of our rating changes, incorporating new information before a company's updated financials are filed. As with all of our pillars, we view the Distance to Default score as an early indicator of default risk, and a key component of our process, but not sufficient on a standalone basis. The Distance to Default algorithm was particularly informative in the recent bankruptcy filing of Ambac in November of this year, the only incident of default within our credit coverage universe since inception. As a component in our insurance credit rating process, Distance to Default factored into our initial credit rating of C for Ambac, signaling imminent default, which subsequently occurred.

The graph below shows the deterioration of Ambac's Distance to Default score during its path toward bankruptcy. In February of 2008, the probability of default for this insurer jumped to over 55% from 17%, and advanced to over 90% by the first quarter of this year. It resided at those levels until eventual bankruptcy:


 

How Have Our Ratings Changed Since Our Launch?
We have created a rating transition matrix to reveal movements in our ratings over the one-year period ending December 2, 2010, among the 100 firms we had rated as of a year ago. Click here to open the matrix in a new window.

If there were no changes to issuer credit ratings in this subset of our universe, the diagonal (reading top left to bottom right) would be 100% for each of the categories. The vertical columns show the rating at the beginning of the period, while the horizontal rows reveal the rating after one year.

Of the 17 issuers that were rated BBB as of December 2, 2009, for example, 82%, or 14, were still rated BBB at the end of this measurement period, while we upgraded 12%, or two, to BBB+ and 6%, or one, to A-. Such a transition table reveals how stable or volatile our ratings have been during the past year. We expect to update this table on a quarterly basis to provide ongoing transparency to investors. We expect our ratings to change more over a given time period than those of the agencies, given that our credit rating system is built to incorporate new information in a very timely manner. Out of the 100 issuers that we have covered since December 2, 2009, the table below lists those that we have upgraded or downgraded, ordered by date of change per category:

  From To Date Changed Upgrades       Abbott ABT AA AA+ 8/23/2010 Avery Dennison AVY BBB- BBB 8/9/2010 CBS CBS BB BB+ 7/19/2010 Kansas City Southern KSU BB- BB 6/28/2010 CSX CSX BBB BBB+ 6/28/2010 Norfolk Southern NSC BBB BBB+ 6/28/2010 Union Pacific UNP BBB A- 6/28/2010 Temple-Inland TIN BB+ BBB- 6/1/2010         Downgrades       Thermo Fisher TMO AA AA- 11/22/2010 Genco GNK BB BB- 8/16/2010         Other       Scholastic SCHL BB+ Dropped 5/3/2010 Source: Morningstar

Some of Our Divergent Views on Credit Quality Relative to the Agencies
One of our key goals is to provide investors with a new voice in credit research. The table below offers a subset of issuers where we are materially more positive than the incumbent agencies. Many of the names on this list fall in the healthcare and technology sectors, with major differences driven in part by our moat-informed assessment of business quality:

Issuer Sector Morningstar
Rating
Avg. Notch Difference
Biogen Idec BIIB Health Care AA- 5 Clean Harbors CLH Business Services BBB+ 4.5 Zimmer ZMH Health Care AA 4.5 Symantec SYMC Technology A+ 4 Amphenol APH Technology A 3.5
Source: Morningstar, S&P, Moody's

The Largest Negative Differences
We've also come across a large number of issuers where our assessment of credit quality is materially more negative than those of the agencies. The following table highlights some of the largest rating differences within our coverage universe.

Issuer Sector Morningstar
Rating
Avg. Notch Difference
Assured Guaranty AGO Financial Svs BBB -6.0 Royal Caribbean RCL Consumer B- -4.0 Coca-Cola Enterprises CCE Consumer BBB -3.0 Sunoco SUN Energy BB- -3.0 UPS UPS Industrials A- -3.0
Source: Morningstar, S&P, Moody's

Non-U.S. Coverage
Morningstar is committed to covering non-U.S. issuers, and we currently rate over 100 companies domiciled in Canada, Europe, Asia, and Latin America. Click here to see our current non-U.S. coverage list. The following table highlights some of the largest rating differences between Morningstar and the agencies within our non-U.S. coverage universe.

Largest Positive Differences, Non-U.S.

Issuer Sector Country Morningstar Rating Avg. Notch Difference Bombardier Inc. Industrials Canada BBB 2.5 Alstom Industrials France A 2 ASM International, NV Technology Netherlands BB 2 Covidien, Ltd. Health Care Ireland AA- 2 SABMiller PLC Consumer Defen UK A 2 Data as of Dec. 22, 2010
 

Largest Negative Differences, Non-U.S.

Issuer Sector Country Morningstar Rating Avg. Notch Difference Statoil ASA Energy Norway A- -3.5 Peugeot Consumer Cycl France BB- -2.5 Deutsche Telekom AG Commun Svs Germany BBB -2 Rexam PLC Consumer Cycl UK BB -2 Posco Basic Materials South Korea BBB+ -2 Data as of Dec. 22, 2010

What's Ahead for Morningstar Credit?
As we look ahead, we expect to expand the breadth of our credit coverage to incorporate REITs, global banks, captive finance subsidiaries, and more.

To request additional information on Morningstar's institutional credit research offering, please contact us at credit@morningstar.com.

Brian Nelson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.