Re-rating the agencies
Anumber of former blue-chip names in European corporate credits are in revolt over the new credit ratings assigned to them by the rating agencies. But in moving swiftly to cut ratings and take a broader view of how likely a company is to be able to meet its future liabilities, rating agencies are reacting to criticism from investors that they have been too slow in the past in noticing when a company’s fortunes had changed for the worse. Poor market sentiment towards a company, which may or may not be provoked by rating agency actions, can adversely affect a company’s ease of access to financing, and turn a minor problem into a catastrophe.
To an extent, ratings agencies are struggling to keep abreast of a more efficient and faster reacting credit market. 2000 and 2001 saw a dramatic pick-up in defaults on investment grade names after a period of 10 years when there were almost none. The turn of the century also saw explosive growth in credit derivatives, with volumes increasing at a compound annual rate of almost 80%. For the first time, investors were able to take negative bets on credits. As the corporate landscape worsened, banks started to place a greater emphasis on credit models that use equity market inputs to gauge the credit spread of companies. As equity markets fell with historically record levels of volatility, banks and investors had both the justification and the means to sell off corporate credits. In most cases the price action took place well before rating agencies downgraded.
Fund managers have developed or bought-in models to generate internal ratings for bonds that produce results far more quickly than the in-depth qualitative approach taken by the agencies. Jörg Sihler, head of fixed income at Deutsche Asset Management, comments that investment managers need a far faster result than the agencies are able to supply, and that the agencies eventual action is often discounted by the market by the time that it happens. Comments Sihler “the rating agencies tend to be correct in normal markets but in fast markets they lose influence. Other inputs will have caused the price of bonds to move well before the rating agency changes the rating”.
Fund managers whose investment processes rely wholly on agency ratings will have underperformed severely over this period. To be able to pre-empt market movements, fund managers needed to be engaged in their own credit research, as the agencies’ ratings could not be relied upon as a predictor of change. More recently, the agencies have attempted to be proactive, forecasting instances where a company’s cashflow may be insufficient to meet its future liabilities.
According to Colin Reedie, bond fund manager at Henderson Investors, rating volatility is making the job of a credit investor more difficult, as he explains, “rather than watching the underlying companies, we are watching what the rating agencies are doing”. Reedie suggests that ratings agencies are using a bearish economic outlook as an excuse to make dramatic multiple-notch cuts to ratings, and this has a significant impact on the performance of bonds. A two- to three-notch downgrade would send much of the corporate bond market down below investment grade status. These ‘fallen angels’ suffer the most destructive price action when they fall below investment grade because of their sizeable issues.
Says Reedie “the rating agencies’ risk aversion and market nervousness are creating a minefield for investors”.
Patrick Cassidy, head of investment grade fixed income research at T Rowe Price, considers that there has been a shift in the rating agencies philosophy away from consistency and towards accuracy, which has made ratings necessarily more volatile. Comments Cassidy, “ratings now are better aligned with reality than in the past, but this has created more rating volatility”. T Rowe Price’s own credit research seeks to exploit differences between its own and the ratings agencies’ view of a credit, which he sees as still a significant influence on the market price.
Mark Talbot, head of international bonds at State Street Global Advisors, sees the rating agencies as prey to the vagaries of a much faster and more virulent credit market, suggesting that, whereas the rating agencies have been criticised for making a company’s problems worse, market actions can in themselves create difficulties for companies, that rating agencies would be foolish to ignore. As Talbot comments, “the business may not fundamentally have changed, but reduced access to funding could result in a weaker credit, and the agencies’ ratings have to reflect this”.
Whatever happens to the Basel II accord, its move to adopt ratings for determining the level of banks’ regulatory capital, has turned credit ratings from a market benchmark into a risk management tool. But if the rating itself is volatile, its use for risk control is undermined. Karl Bergqwist, head of credit research at Gartmore, suggests that, whilst ratings agencies bring some systemic stability and transparency to the credit market, the use of ratings for regulatory purposes and for structuring investment mandates should be avoided. Bergqwist notes “central banks, regulators and pension fund trustees all want to view ratings as independent measures of risk, but the question is how to ensure the quality of the rating. Ratings agencies are profit-maximising organisations that will want to employ the minimum number of analysts, and quality could decline further if a certain level of revenues is guaranteed by regulation.”
Most investment managers have built up their own credit teams in response to faster moving credit markets and disappointment at the lack of leadership of the ratings agencies. The days when a manager could rely on a ratings agencies’ assessment are long gone. Comments Bergqwist, “investment managers should be sufficiently on top of a rating that the agency’s actions come as no surprise. The credit markets have increased in size and sophistication and parts of the credit market are now as volatile as equity. Whereas credit analysis used to be done on a shoestring, as the market has moved down the credit curve, more experienced people are needed to make an assessment.” Ratings agencies already appear to be suffering from a brain drain towards the larger asset managers and investment banks. In an effort to make up for a lack of expertise, recent agency research has shifted away from individual company analysis towards making more general pronouncements on sectors, and often the lead analyst on a company will be geographically remote.
Bergqwist notes a breakdown in the relationship between ratings and market pricing since Enron and comments, “ratings have been de-emphasised in risk assessment at Gartmore. We prefer to look at the type of credit, and the structure of the bond as more important indicators of risk. Issues with the same rating can have quite different risk characteristics.”
If ratings bands are used as the basis for determining portfolio composition, ratings volatility will mean that the fund manager is chasing a moving target. If an investment guideline enforces an average rating, there can be dispute as to what convention to use for transposing the letter grade to a number to calculate an average. Sihler notes, “internally we score bonds from one and 20 from AAA to BBB, whereas Moody’s assigns a factor of 360 to BBB risk, making it 360 times more risky than AAA paper. To comply with an average rating using Moody’s estimation of relative risk would require more AAA paper, so reducing the portfolio yield.”