DBRS Releases Commentary on Core Approach: “Rating through the Cycle”

DBRS, Inc. (DBRS) has today published a new commentary called “Rating through the Cycle: DBRS’s Core Approach and its Effect on Sovereign Ratings.” The commentary provides details of the process of rating through the credit cycle that DBRS uses to determine credit ratings across all of its business lines, though this report explains the approach in the context of rating sovereign debt.

Comparative ratings are used to illustrate how DBRS’s approach to rating through a credit cycle tends to result in more stable, consistent, predictable ratings, which DBRS understands is preferred by many investors. The commentary compares the historical rating actions on all 29 countries DBRS currently rates to demonstrate how its ratings tend to be more stable and consistent during periods of crises, such as the global financial crisis and more recently the European sovereign debt crisis. Comparisons are also made to sovereign bond yields to show how during periods of extreme market volatility, DBRS’s ratings predict long-term default risk.

Under this perspective of “Rating through the Cycle,” DBRS takes a longer term view in evaluating a debt issuer, looking through normal cycles in the economy. DBRS’s core concept of rating through the cycle is to consider the fundamental credit strengths that endure through a downturn. As a result, normal economic cycles do not generally result in sizeable ratings changes. That means DBRS’s downgrades during a downturn are often fewer and smaller, while upgrades are also fewer and smaller during a period of economic expansion.

For example, during the early stages of the European debt crisis, DBRS’s sovereign ratings on many European countries were equal to or lower than certain other agencies’ ratings in many cases. Now, as the crisis appears to be fading, DBRS has the highest rating on many of the countries that were at the center of the crisis (Ireland, Italy, Portugal and Spain). During the depths of the crisis, DBRS took fewer and smaller rating actions than its peers on those four countries, all while financial markets were extremely volatile and pointing toward significant risk of default. Now, bond yields have recovered to pre-crisis levels (or even lower in some cases) that more closely reflect default risk that DBRS’s ratings have implied for more than a year in the cases of Ireland, Italy, Portugal and Spain.

Because DBRS is looking through normal cycles in the economy, sovereign ratings move more from structural changes in the credit fundamentals than from the normal cyclical swings in the sovereign’s economy. The sovereign analysis places greater emphasis on fundamental considerations such as the quality of economic and fiscal policymaking, fiscal responsibility, debt sustainability, economic diversification, price stability and the stability of political systems. DBRS strongly considers structural changes that improve productivity over the medium term. DBRS is also willing to tolerate a high deficit as long as there is a medium-term plan to reduce it over time without choking off a recovery.

Nevertheless, economic cycles can affect credit ratings. More severe economic downturns can reveal structural weaknesses that otherwise would not have been seen during better economic periods. External factors, such as geopolitical risk can affect a rating as well.