Wolves in Bondland

Like many investors, we rely on the integrity of information supplied by public credit rating agencies including Standard & Poors and Moody’s to help assess the risk of default on corporate, municipal, and mortgage backed bonds. Lately we’ve been asking are these ratings still useful or are investors just being naive while wolves posing as sheep circle the pasture in search of the weak and unwary? Given the amount of money at stake, it’s a reasonable question.

Along with a host of other investment attributes, credit risk has its price. Naturally, bond buyers expect full and fair compensation for 100% of the credit risk they assume. However, when the actual amount of credit risk is misrepresented by collusion (or even the appearance of collusion) between issuer and watchdog, investors wind up getting fleeced out of a small slice of return they ought to have earned.

Recently, Standard & Poors reached a $1.38 billion agreement with the U.S. Department of Justice and 19 states to settle civil allegations S&P improperly inflated  credit ratings on scores of mortgage backed bonds prior to the 2008 financial crisis. In a scathing indictment, U.S. Attorney General Eric Holder accused S&P of lying over claims its “ratings were objective, independent, (or) uninfluenced by potential conflict of interest“.  S&P fought back, but in the end they caved-in under the weight of the evidence. 

While it’s easy to applaud the hard line state and federal prosecutors took in this latest round of negotiations, the settlement really won’t do anything to restore the gaping holes S&P helped tear in the savings and retirement plans of millions of ordinary investors. That ship has already sailed. Shockingly though, the settlement leaves intact the very same structural conditions that created the problem in the first place. This means a recurrence of the same problem is, more likely than not, just a matter time.

What’s of concern here is the simple fact that S&P is paid by issuers to rate securities the very same issuers intend to sell to the public. Securities that can be sold for a lot more money if they come packaged with a credit rating that’s been tweaked upward by an intentional or unintentional thumb on the scale.

Let’s examine a hypothetical case.

A respected corporate bond trader confirms the representative spread between generic BB+ (non investment grade) and BBB- (investment grade) rated bonds with identical 10 year maturities has been hovering around 45 basis points (0.45%). A corporate issuer coming to market with a routine $500 million deal priced at par would realize savings of $22.5 million over the 10 year life of the bond if the credit rating happened to be bumped up a half notch. Depending on the industry sector, the actual spread between the two credit ratings could be more. A lot more. Multiply that spread by the volume of debt a corporate treasury department may need to borrow or refinance and it’s easy to see why there is pressure to influence the outcome of a ratings review. Back here in the heartland, we call that motive.

Is there a viable alternative? Unfortunately, not really. Independent bond rating services purchased by investors through subscription have proven to be notoriously unprofitable business models. There is little cause to think that is going to change anytime soon.

So let’s end this charade of paying false homage at the altar objectivity and proceed with the only realistic fix that’s available to the investing public: disclosure. As the saying goes, sunshine is a very powerful disinfectant. I’d be willing to bet investors would be a lot more circumspect about the usefulness of credit ratings if they were accompanied by a red letter warning label broadcasting the following statement:

“These securities have been rated according to proprietary standards that are both quantitative and qualitative. We do not publish these standards nor do we make our working documents available for public inspection. Buyers should be aware we have a material and ongoing business relationship with the issuer that will impact our ability to render an unbiased and objective opinion”.

Is compulsory disclosure of the inherent conflicts of interest that influence rating decisions the perfect solution? Not by a long shot. But it might be the best that can be done for now.  It’s certainly a whole lot better than policies that turn a blind eye whenever wolves slip into the flock dressed to kill.

Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management who affirms neither wolves nor sheep were harmed in the writing of this article. The opinions expressed in this article are his own.