Standard & Poor’s Underlying Rating: Applications and Benefits
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Summary:
Standard & Poor’s Underlying Rating (SPUR) is a credit rating that evaluates the creditworthiness of a municipal bond issuer without considering the impact of external credit enhancements, such as insurance or guarantees. SPUR provides investors with a clear, unvarnished view of the issuer’s intrinsic credit quality, allowing for a more accurate assessment of the risk involved in investing in a particular bond.
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Introduction to Standard & Poor’s
Standard & Poor’s (S&P) is a globally recognized financial services company known for providing credit ratings, investment research, and data analysis. Established in 1860 by Henry Varnum Poor, S&P has grown to become one of the most influential credit rating agencies in the world. S&P plays a critical role in the financial markets by evaluating the creditworthiness of issuers and providing ratings that help investors make informed decisions.
S&P offers a variety of credit ratings, including those for sovereign nations, corporations, and structured finance products. These ratings range from ‘AAA’ (highest credit quality) to ‘D’ (default), reflecting the likelihood of timely payment of principal and interest. The ratings are widely used by investors, fund managers, and financial institutions to assess risk and make investment choices.
What is an underlying rating?
The Underlying Rating, or SPUR, specifically evaluates the credit quality of an issuer without taking into account any external credit enhancements. This stands in contrast to the more general credit ratings that may incorporate the benefits of insurance, letters of credit, or other forms of guarantees that can artificially elevate the perceived creditworthiness of an issuer.
SPUR is particularly important for municipal bonds, as many municipalities purchase bond insurance to improve their ratings and reduce borrowing costs. By examining the underlying credit quality, SPUR provides a more transparent and accurate measure of the issuer’s ability to meet its debt obligations.
Methodology behind SPUR
S&P employs a rigorous methodology to determine SPUR, involving a thorough analysis of various factors that influence an issuer’s creditworthiness. The key criteria include:
- Financial health of the issuer: This involves examining the issuer’s financial statements, including revenue sources, expenditure patterns, budgetary practices, and overall fiscal stability. Key metrics such as debt levels, liquidity, and reserve funds are also scrutinized.
- Economic conditions: The economic environment in which the issuer operates plays a significant role in determining SPUR. This includes analyzing the local economy’s strength, employment rates, income levels, and demographic trends.
- Management quality and policies: The effectiveness of the issuer’s management team and their policy decisions are critical to creditworthiness. This includes evaluating governance practices, strategic planning, and the ability to respond to financial challenges.
Applications of SPUR
SPUR is a valuable tool for various stakeholders in the financial markets:
- Investors: For investors, SPUR provides an unfiltered view of an issuer’s credit risk. This is particularly useful when comparing bonds with similar external ratings but differing underlying credit qualities. SPUR helps investors make more informed decisions and tailor their investment strategies accordingly.
- Financial institutions: Banks and other financial institutions use SPUR to assess the risk associated with lending to municipalities or purchasing municipal bonds. This helps in pricing loans and bonds more accurately and managing portfolio risks.
- Bond issuers: For municipalities and other bond issuers, SPUR serves as a benchmark for improving their creditworthiness. By understanding the factors that influence their SPUR, issuers can implement better financial practices and policies to enhance their intrinsic credit quality.
Benefits and limitations of SPUR
Benefits of SPUR:
- Transparency: SPUR offers a clear and unbiased assessment of an issuer’s credit quality, independent of external enhancements. This transparency is crucial for investors who need to understand the true risk associated with their investments.
- Risk management: By providing a deeper insight into an issuer’s financial health, SPUR aids in better risk management for investors and financial institutions. It helps in identifying potential default risks early on.
- Improved investment decisions: SPUR allows investors to make more informed decisions by comparing the intrinsic credit qualities of different issuers. This can lead to more strategic investment choices and potentially higher returns.
Limitations of SPUR:
- Complexity: The methodology behind SPUR is complex and may not be easily understood by all investors, especially those without a financial background. This complexity can sometimes obscure the rating’s implications.
- Subjectivity: While S&P employs rigorous analysis, some aspects of SPUR involve subjective judgment, particularly in the qualitative assessment of management quality and economic conditions. This subjectivity can introduce variability in ratings.
- Limited scope: SPUR is primarily used for municipal bonds and may not be as relevant for other types of securities. Investors focusing on other asset classes might not find SPUR as useful.
Case studies
Case study 1: Detroit’s municipal bonds
In 2013, Detroit filed for bankruptcy, the largest municipal bankruptcy in U.S. history. Prior to the bankruptcy, Detroit’s bonds were insured, which masked the city’s deteriorating financial condition. SPUR, however, provided a clearer picture of the underlying credit quality, indicating significant fiscal distress. Investors who relied on SPUR were better prepared for the potential default compared to those who only considered the insured ratings.
Case study 2: California’s recovery post-2008 financial crisis
Post-2008, California faced severe fiscal challenges, leading to downgrades in its credit ratings. However, the state’s SPUR highlighted its strong economic fundamentals and proactive financial management. Over time, California implemented budgetary reforms and improved its financial practices, which was reflected in an improving SPUR. Investors who monitored SPUR were able to identify California’s recovery trajectory early and benefited from investing in its bonds as the state’s credit quality improved.
FAQs
What is the difference between SPUR and other S&P ratings?
SPUR specifically evaluates the issuer’s credit quality without considering external credit enhancements like insurance or guarantees. Other S&P ratings may incorporate these enhancements, which can elevate the perceived creditworthiness.
How often are SPUR ratings updated?
SPUR ratings are updated regularly, typically on an annual basis or when there are significant changes in the issuer’s financial condition or economic environment. However, S&P may also update ratings in response to specific events or developments.
Can SPUR ratings be appealed or changed?
Yes, issuers can appeal their SPUR ratings if they believe there are inaccuracies or if they can provide additional information that may affect the rating. S&P reviews such appeals and may adjust the rating if warranted.
Key takeaways
- SPUR provides a clear, unbiased view of an issuer’s intrinsic credit quality by excluding external credit enhancements.
- It plays a crucial role in helping investors, financial institutions, and bond issuers make informed decisions and manage risks effectively.
- While SPUR offers significant benefits in terms of transparency and risk assessment, it also has limitations, including complexity and subjectivity.
- Real-world examples, such as Detroit’s bankruptcy and California’s recovery, illustrate the practical applications and importance of SPUR in the financial markets.