In December 2009, Standard & Poor’s (“S&P”) announced that, beginning March 31, 2010, it will begin withdrawing ratings from structured notes with variable principal payments linked to equity prices, commodity prices, or equity or commodity indices. This decision affects only certain structured notes; S&P will continue to rate equity- or commodity- linked notes provided that the return of principal is guaranteed, as well as products that provide solely for a conditional interest payment. Additionally, S&P will continue to rate credit-linked notes and provide issuer credit ratings.1
S&P’s adjustment is an attempt to avoid confusion among the different risks that underlie structured notes: market risk and credit risk. Credit risk applies to all obligations, and reflects the likelihood that the issuer will have the funds available at maturity to pay the principal amount. Market risk applies only to notes in which payment depends on an external measure, and reflects the likelihood that the note’s terms will result in a return of principal. By way of example, an issuer might sell a structured product where the terms provide for repayment of principal only if the gold spot price has increased on a date twelve months after settlement. Credit risk is the likelihood that the issuer will have sufficient financial resources available to pay its obligations whether or not gold appreciates; market risk is the likelihood that gold will, in fact, appreciate twelve months down the line.
An investor could suffer serious consequences if she confuses market risk and credit risk; different notes can pose identical credit risks yet present very different overall risk profiles. The concern is that S&P’s ratings—which apply only to credit risk—might add to this confusion by being misread as applying to market risk. Driven by these concerns, S&P released a request for comments in May 2008, asking market participants to remark on an updated framework for structured note ratings.2 S&P’s announcement last month is simply another step in this ongoing process to minimize confusion, this time by withdrawing its ratings on notes where the repayment of principal depends, directly or indirectly, on equity or commodity prices. In doing so, S&P seeks to highlight the primarily non-credit risks associated with those structures.
Structured note issuers may need to update their disclosures in light of S&P’s decision not to rate certain structured notes, at least to the extent they reference their ratings (that is, their issuer credit ratings) in the offering documents. Specifically, structured note issuers should ensure that, when including issuer credit ratings in a prospectus, they indicate that the ratings apply only to the issuer, and not to the structured notes. These changes by the S&P are only the most recent in a string of updated disclosure issues for structured notes issuers,3 issues that structured note issuers and underwriters should continue to monitor.