“Which credit risk model should I use?” is a question that is even more relevant in times of market stress, such as the unpredictable COVID-19 era. Whilst “the one with the best performance” may seem like a reasonable answer, the (un)fortunate fact is that credit risk models are tailored for different objectives and thus exhibit a broader set of distinct performance characteristics.
The credit risk assessments of different models are thus not always aligned. However, these differences are welcomed and should be seen as complementary insights into the aspects of a counterparty’s credit risk. Leveraging various credit risk assessments in parallel enables a streamlined and comprehensive approach to gauge counterparty credit risk. To that end, we introduce the S&P Global RiskGauge model, a novel approach that integrates assessments of multiple credit risk models into a single credit score. We demonstrate how such an approach can help track a company’s credit risk during the COVID-19 pandemic and detect early warning signs of default.
Managing Credit Risk with Credit Analytics
A counterparty credit risk analysis should aim to leverage multiple sources of information to help support an informed decision-making process. Risk factors such as company financial ratios, the macroeconomic environment, and market indicators provide complementary information and can be utilized in the credit risk assessment process.
S&P Global Market Intelligence’s Credit Analytics suite consists of multiple statistical credit risk models that facilitate an easy, scalable and time-efficient evaluation of credit quality. Credit Analytics’ market- and fundamentals-driven models provide tools for a comprehensive analysis of credit risk and enable assessment of the probability of default (PD) of rated, unrated, public, and private companies across the globe:
- CreditModel™ (CM) is a credit scoring model that leverages both financial data and the most relevant macroeconomic data, to generate a quantitative credit score that statistically matches a credit rating issued by S&P Global Ratings. The model generates long-term credit risk assessments, and is best positioned to assess through-the-cycle creditworthiness.
- PD Model Fundamentals (PDFN) is trained using default indicators, and incorporates both financial and business risk to generate a PD value for public and private corporations of any size. The model produces PD values with the stability of circa one-year, in line with the materiality of changes of company financials.
- PD Model Market Signals (PDMS) is an enhanced market-driven credit risk model, based on the structural approach proposed by Merton. The model links market movements to the company’s PD. The PDMS produces reliable early warning signals useful for credit surveillance, quick initial screening, and timely monitoring of credit risk trends. The model is highly sensitive and generates short-term, point-in-time PD values which are updated daily to reflect current market information.
S&P Global Market Intelligence RiskGauge model – an integrated credit risk view
S&P Global’s RiskGauge model complements the Credit Analytics suite, and optimally combines the outputs of the three standalone credit risk models – CreditModel™, PD Model Fundamentals, and PD Model Market Signals – into an overall credit risk score.
The integration of CM, PDFN, and PDMS is tailored to simultaneously optimize the model’s default prediction power and statistical alignment of credit scores. The S&P Global RiskGauge model achieves this by intelligently building on the strengths of each of the three standalone models – CM’s long-term and stable credit quality, PDFN’s sensitivity to changes in the company’s fundamentals, and PDMS’s market-implied information, and produces a comprehensive credit risk assessment.
As an output, the S&P Global’s RiskGauge score generates an overall PD value and maps it to S&P Global Market Intelligence’s credit scores. Additionally, the model also provides a credit risk assessment on a 1-100 scale. A score of 100 (1) corresponds to companies with the lowest (highest) credit risk, whilst a score of 50 corresponds to the average credit risk at the boundary between investment-grade and speculative-grade credit scores. The model offers a streamlined view of counterparty credit risk, and generates PD estimates and credit scores every day for a broad range of private and public companies globally, across a full range of company sizes and industries.
Source: S&P Global Market Intelligence. As of November 15, 2019. For illustrative purposes only.
Case Study – The default of LATAM Airlines
LATAM Airlines Group S.A. (LATAM Airlines) is the largest airline in Latin America. On May 26, 2020, LATAM Airlines voluntarily filed for bankruptcy under Chapter 11 with an aim to resize its business and balance sheet to achieve long-term sustainability in the post- COVID-19 era.
Figure 2 shows the evolution of credit risk for LATAM Airlines from January 2019 to June 2020. Throughout 2019, LATAM Airlines creditworthiness was relatively stable. S&P Global Ratings Issuer Credit Rating (ICR) equaled ‘BB-’, whilst S&P Global’s RiskGauge score fluctuated between ‘bb’ and ‘b’. The underlying three standalone models (CM, PDFN, and PDMS) reflect different credit risk drivers and thus provide slightly different credit risk scores. The PDMS shows the greatest volatility, as expected for market-driven models, whilst CM and PDFN reflect the fundamental changes in the company’s financial performance and are thus more stable.
As with many other airlines, LATAM Airlines was significantly impacted by the travel restrictions due to the COVID-19 pandemic. The airline generated around $10 billion in revenue in 2019, but it was operating at only 5% of its capacity in May 2020.7 This eroded the company’s liquidity position and significantly increased their debt restructuring risks. Consequently, S&P Global Ratings gradually lowered the company’s ICR to ‘CCC-’ by May 22.
Since the beginning of 2020, the S&P Global RiskGauge credit score deteriorated from ‘bb-’ to ‘ccc+’ by late May. This decline was a result of deteriorations in all three standalone credit models’ scores. The PDMS provided an initial early warning signal of adverse market conditions and indicated the company’s distressed outlook. The CM and PDFN scores also deteriorated substantially when Q1 2020 financial statements showed considerably weakened financial fundamentals. By combining this complementary information, the S&P Global RiskGauge score timely reflected LATAM Airlines elevated credit risk a few weeks prior to the consecutive changes in the S&P Global Ratings ICR and detected early warning signs of the subsequent default.
Figure 2: Historical evolution of credit risk for LATAM Airlines Group S.A
Source: S&P Global Market Intelligence. As of June 15, 2020. For illustrative purposes only.
Every credit risk model provides a unique insight into a company’s creditworthiness from a different point of view. It is recommended to treat multiple credit risk measures as an ensemble to effectively leverage their respective strengths. S&P Global’s RiskGauge model combines market-implied and fundamental-based information to provide a comprehensive credit risk assessment and help support an informed decision-making process.
To learn more about our RiskGauge Reports click here.
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 S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD credit model scores from the credit ratings issued by S&P Global Ratings.
 S&P Global Market Intelligence: “CreditModelTM Corporates 2.6”, White Paper, February 2020; S&P Global Market Intelligence: “CreditModelTM Financial Institutions”, White Paper, February 2019
 S&P Global Market Intelligence: “PD Model Fundamentals - Public Corporates”, White Paper, February 2020; S&P Global Market Intelligence: “PD Model Fundamentals – Private Corporates”, White Paper, February 2020; S&P Global Market Intelligence: “PD Model Fundamentals – Banks”, White Paper, January 2020
 Merton, R.C.: “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” Journal of Finance, 29, 1974
 S&P Global Market Intelligence: “PD Model Market Signals”, White Paper, September 2019
 S&P Global Market Intelligence: “RiskGauge Model from S&P Global Market Intelligence”, White Paper, June 2020
 The S&P Global RiskGauge methodology is fully adaptable and can generate final PD values using any combination of available inputs.
 S&P Global Ratings: “Latam Airlines Group S.A. Ratings Lowered To 'D' On Chapter 11 Filing'”, Research Update, May 27, 2020.