A show of strength

The use of credit ratings in pensions circles is a relatively new idea, as indeed is the whole area of the employer covenant.

A credit rating is a long-term measure that a company will default on (i.e. not pay) its financial obligations, such as its pension scheme. It is long-term because it looks at the vulnerability of the company over the economic cycle and the risk of default can be demonstrated over a number of years. Ratings are produced individually by analysts using primarily confidential (not just public) information and are used by investors and financial institutions to determine the risk within a company or its issued debt.

A credit score is not the same as a credit rating. Credit scores are produced under a largely automated process using models and a number of data feeds, and may include a one year probability of insolvency. They would be used by companies that wanted to know the risk of extending a line of credit to another company or individual. The automated process means they have wide coverage which makes them suitable for bulk applications such as the Pension Protection Fund.

Although terminology can vary, in financial markets at least a “credit rating agency” would be assumed to be an organisation such as Standard & Poor’s that produces credit ratings, whereas organisations producing credit scores might be labelled “credit scoring bureaux”.

Credit ratings are not a substitute for advice as rating agencies cannot give advice. In a covenant review exercise, rating agencies can assess the strength of a company – expertly we would claim given over 140 years of assessing companies. But we cannot provide subsequent advice.

There will be times when advice will be needed in addition to a covenant assessment, there will be times when it is not. This will depend on, among other things, the strength of the covenant revealed by the assessment and the ability and expertise on the trustee board to negotiate with the employer.

Credit ratings can be, and have been, used by our pension trustee clients to negotiate recovery plans with employers. The presentation of our covenant analysis based on ratings methodology shows the risk of default over a number of years. Although only a broad guide as to the level of risk, it does nevertheless give trustees a starting point and a framework for their funding negotiations.

The importance of historical information should not be ignored. It can provide an important indication of capital structure and demonstrated cashflow, and draft and managerial accounts can reduce the time-lag. As with other covenant assessment providers, we sometimes have limited non-public information available. In the hands of an experienced analyst who rates many other similar businesses (and rating agencies are not short of experience here), even an assessment based on limited information can still be robust. Clearly though, if the company is planning a dramatic shift in the business or its financing, relying on historical information exclusively will be of limited use.

In any event, assessing the strength of a business is not just about the numbers, historical or prospective. It is equally important to appreciate the more qualitative factors such as the business environment and competitive position. It is these factors which are crucial for a forward-looking assessment and will often drive the analysis.

Finally, trustees’ access to credit ratings is not limited only to existing public ratings. As the panel correctly points out, the public rating is likely to be on the parent or group which may not be directly relevant for the pension scheme. Trustees can however obtain covenant analysis from a credit rating agency tailored to their circumstances.

Covenant analysis based on credit ratings can provide one of the clearest indications of an employer’s strength.

Richard Hall is associate director of pension services at Standard & Poor’s