How Our Credit Ratings Have Performed

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. We've reached the one year anniversary of the launch of Morningstar's Corporate Credit Ratings. I am joined here today with Brian Nelson, he is the Director of Credit Methodology; and Julie Stralow, who is a Credit Analyst, to take a look to see how the ratings have performed over the last year and also with a few bond picks.

Brian, Julie, thanks for talking with me today.

Julie Stralow: Thanks for having us.

Brian Nelson: Thanks.

Glaser: So, Brian, can you refresh people's memories about exactly how Morningstar's credit ratings are different from those that you might get from, say, Moody's or S&P or one or the other major rating agencies?

Nelson: Absolutely. Morningstar has launched over 650 Issuer Credit Ratings this year and the methodology that backs them is supported by four unique pillars. Within our methodology and within our business risk analysis for each company, one of the key rating factors that we look at is a company's economic moat. We feel that gauging the long-term competitive advantages of a company allows us to better gauge the long-term cash generating capacity of the company in order to meet future debt obligations.

Our views on competitive advantages are significantly more in-depth in terms relative to other credit rating firms. In fact, we tend to be more favorable on firms with wide moats relative to other credit rating firms and less favorable with companies with no moats relative to other credit rating firms.

So that's one way that we differ, but we also have other components in it. Another one is the Cash Flow Cushion. This Cash Flow Cushion is forward-looking indicator that gauges a company's liquidity and refinancing risk over a five-year horizon. Because we have this forward-looking view, we are able to pinpoint periods in the future where cash shortfalls are likely to occur and it also allows us to anticipate changes in a firm's credit profile over the next five years.

Glaser: So, if you think about how the credit ratings have changed or how we've expanded over the last year, what are some of the initiatives the team has been working on?

Nelson: Since we launched on 100 firms in December of '09, subsequent to that we've launched credit rating methodologies for banks and insurers. In fact, our coverage universe now spans across all the sectors that we cover. On the product front, we've rolled out a Credit Weekly piece for institutional investors and also a Best Ideas list.

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Glaser: Now, how have these ratings performed? Really it sounds great, but the proof is in the pudding. How has it been going?

Nelson: The key support for our Issuer Credit Rating rests in our issuer rating methodology. So, in terms of how our methodology has performed, the Solvency Score for non-financials, which is another component within our rating methodology, has been effective in predicting a number of defaults this year. In fact, in the instances of Radio One, U.S. Concrete and Blockbuster, the Solvency Score highlighted significant default risk nearly two years in advance of that event.

Also the fourth pillar, as I mentioned, our business risk assessment, our Cash Flow Cushion, Solvency Score, our fourth pillar is actually a Distance to Default algorithm, which is a market-based indicator. This market-based indicator, which rolled into our insurance credit rating methodology, allowed us to get ahead and put an Issuer Credit Rating of a C on Ambac, which subsequently defaulted. In fact, the Distance to Default measure highlighted a significantly higher probability of default for Ambac nearly a year and a half in advance of the eventual bankruptcy.

Glaser: A lot of investors see these AAA, BBB minus, that don't necessarily mean a lot of them. How do we translate these credit ratings into actual investable ideas?

Nelson: Right. So, essentially, our issuer rating methodology is a ranking mechanism for probability of default. When you arrive at an Issuer Credit Rating for a company, essentially it dictates the spreads that we would demand on the underlying issues of the firm, absent any technical bond considerations and whatnot. So, our methodology and the Issuer Credit Rating provides the bedrock for our investment ideas.

Glaser: Now, Julie, one of the places that we've really had a disconnect between where we put our ratings and where some of the other rating agencies have is in the healthcare space, can you describe a little bit why our take is maybe slightly contrarian there?

Stralow: Sure. I think in the healthcare industry, there is basically a lot of opportunities to develop moats. There's a variety of patent protected products, high regulatory requirements, difficult manufacturing processes, big marketing requirements that are associated with a lot of healthcare products and a lot of healthcare firms.

So, even though a company may be competing in a relatively small niche, we think that they often have a chance to develop a moat. So, some of our very wide moat companies are skewing a bit higher than the rating agencies have them because we think they sometimes use sales size as a proxy of business quality, while we rely on the moat.

Glaser: So it's a good way our competitive advantage analysis really gives us a leg up on the credit analysis as well. Are there any particular bond picks that you think look attractive right now?

Stralow: Yeah, I think two outstanding issues right now could be interesting bond plays, one from Biogen and one from Zimmer. Both of those companies we think have wide moats. However, at the rating agencies, they are actually four to five notches lower on their credit ratings than us. That I think has to do with their relatively small sizes. Both Biogen and Zimmer have less than $5 billion in sales, but we think that they are very competitively advantaged in the niches that they play in.

For example, Biogen provides biologic drugs and those have patents that protect them and they also have very difficult manufacturing processes associated with them. So we think that they have a wide moat associated with their business.

Zimmer is a top tier player in orthopedic products and we think that that company or that industry, in particular, has a lot of sticky surgical relationships and there is not a lot of switching that goes on. So, we see that as a very defensible niche to play in. Zimmer is one of the best at it.

So, both of those companies have wide moats, they have really, really clean balance sheets and we think that the yield opportunity compared to the risk that you are taking on when buying their debt is quite a bit higher than average.

Glaser: That sounds great. Julie, Brian, thanks very much for the update. It was great talking to you.

Stralow: Thank you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.