Moody’s set for preferred ratings methodology changes

Moody’s Investors Service, the New York-based rating agency, plans to change its method for rating preferred stock in order to utilise the same scale it uses for its corporate debt ratings. Like its debt ratings, the firm’s preferred ratings will reflect expected loss rates and default risk, rather than only the latter. But changing the criteria may cause some preferred ratings to shift downward, and Moody’s is emphasising that these shifts should not be considered downgrades.

The move comes three years after Fitch and two years after Standard & Poor’s made similar refinements to allow direct comparisons between their ratings on different types of corporate securities.

Moody’s predicts that some companies may see apparent downgrades of two notches as their preferred stock is brought under Moody’s debt rating system within the next three months. The challenge Moody’s faces is to educate investors, intermediaries and issuers on the rationale behind the change. Fitch faced a similar challenge when it aligned its ratings systems. “We made sure to inform investors how and why we made these changes so they did not cause any market dislocations,” says Nancy Stroker, group managing director at Fitch in New York. “I think the changes have been very well accepted.”

But when Standard & Poor’s converged its preferred stock and debt ratings, “we took a lot of flack. We actually had people threaten to sue us,” says Solomon Samson, chief rating officer for corporate ratings in New York.

Moody’s describes its proposal in a paper outlining statistical refinements to its expected loss rating methodology. It says the approach is now possible due to new research comparing historical loss rates on different corporate securities over a period of 10 years. “We want to put forward an identifiable foundation to justify our notching conventions,” says Jerome Fons, managing director in the financial institutions group at Moody’s in New York. “It is becoming increasingly important to demonstrate how rating recommendations fit into an expected loss framework,” he says.

Making rating distinctions – or notching – the secured, unsecured and subordinated debt and preferred stock of a single company depends on the probability of default and expected loss rates. The various liabilities share the same probability of default. Differences in their expected loss rates are determined by their relative priority of claim in bankruptcy.

Moody’s analysis of expected loss shows that preferred stock recovers an average of only five cents on the dollar in the event of default, compared with 17 to 28 cents for subordinated debt. Holders of senior unsecured debt recover around 49 cents, while secured debt recovers approximately 64 cents on the dollar. For example, an issuer rated A1 for unsecured debt would generally be rated A2 for subordinated debt. Under the new system, the rating for preferred stock in this example will change from a1 to A3.

While investors did not request that Moody’s change the preferred stock ratings or provide an analytical explanation for its recommendations, the agency says the focus on expected loss in the rating process will facilitate accurate risk/return comparisons for investors. “We hope to clarify the meaning and usefulness of our ratings,” says Fons. “So far the response [from investors] has been positive.”