CFA Commentary l A Member of the CFA Institute Global Network of Societies Rating Agencies Love them or hate them they are here to stay By now, anyone in Barbados who reads the newspapers or listens to news broadcasts with any regularity is familiar with the names of Standard & Poor s Financial Services (S&P) and Moody s Investor Service. These are the two credit rating agencies (CRAs) that regularly express opinions on Barbados ability to repay its foreign borrowings. Both agencies have featured prominently in local news recently because their opinions of us have not been favourable. Indeed, over the past seven years they have steadily downgraded their ratings on Barbados debt, implying that the island may not be able to repay instalments of interest and principal as they come due. That s a nice way of saying that the island is dangerously close to defaulting on debt repayment. It s not flattering news, and yet Barbados must pay these agencies to produce it. Say what? Yes, countries and companies pay substantial fees to CRAs to provide a rating, regardless of the outcome. Without such a rating, it is almost impossible to borrow money by issuing bonds and other securities in public markets. You can forget about raising US dollars in New York, sterling in London or Swiss francs in Zurich. Investors who know little or nothing about the country or company simply won t chance it. Over the long life of a bond, they are keen not only to receive a return on their money, but also the return of their money. A rating by S&P or Moody s helps them assess the risk of this not happening. 2017 CFA Society Barbados 1
In essence, CRAs play a middleman role in the relationship between investors and entities looking to raise money. Their basic function is to evaluate the financial strength and creditworthiness of companies or countries. Put another way, ratings reflect an agency s degree of confidence that the borrower will be able to meet promised payments of interest and principal. Several factors have led to the near universal use of credit ratings in the bond markets and the dominant role of the major credit rating agencies. These include: n Development and expansion of bond portfolio management and the accompanying bond indices. What ratings mean Agencies such as S&P and Moody s use ratings systems based on the alphabet to attribute the degree of risk associated with a country s bonds, and the debt is rated at the time it is issued. (However, the creditworthiness of both the debt and the issuer is reevaluated periodically to determine if a change in rating is called for.) Credit Ratings Chart n Independent assessment of credit risk n Ease of comparison across bond issuers, issues and market segments n Regulatory and statutory reliance and usage n Issuer payment for ratings n Huge growth of debt markets For example, S&P s highest rating is AAA. The ratings then descend to AA, A, BBB, BB, B and so forth, all the way to D, with signifies that the organization is in default. A bond rated above BBB- is considered to be investment grade, whereas those rated BB+ and below (one notch below 2017 CFA Society Barbados Top 4 2
BBB-) is considered to be a speculative or commonly referred to as a junk bond because of the higher risk that the issuer may default. A rating of C implies substantial risks exist or that default is imminent. An AAA rating from S&P is extremely rare. There are only a handful of companies in the world, such as Exxon, Johnson & Johnson and Microsoft that qualify. Even the mighty General Electric lost its AAA rating in 2009 during the financial crisis. When it comes to countries, only Canada, Norway, Denmark, Hong Kong, Lichtenstein and Luxembourg possess an AAA without a negative outlook. Ironically, these are all relatively small countries. Others have the AAA rating but downgrades may be in the cards. S&P has the United States rated at AA+, while Moody s rates the country as Aaa, its highest rating. Moody s uses an alphabet system as well, although in a somewhat different combination that also involves numbers. For example, Aaa is its highest rating while Aa1 is a notch lower. Moody s lists nine ratings from Aaa to Baa3 that signify investment grade. Anything below is considered to be speculative, which is polite terminology for junk bonds. Ratings also influence the price and interest rates of bonds. In plain terms, the higher the rating, the lower the interest rate. Investors are prepared to take a smaller return on their investment in exchange for greater security. For companies and countries alike, paying a low interest rate means a better chance of being able to borrow more if and when they need. This ability can be a huge competitive advantage to companies who can respond quickly to opportunities because they can raise capital easily and cheaply. All of this is why it is so important for entities to keep their credit ratings within the range considered investment grade. This is particularly true for countries who wish to raise money through bonds in huge amounts that only large institutional investors could afford to buy. Many institutional investors such as banks, insurance companies, pension funds and many fixed income funds own billions of dollars worth of investment grade bonds because it is the policy of most not to include in their portfolios anything that isn t investment grade. (However, funds of many types also hold substantial amounts of junk bonds which generally yield more. At times they can reward investors with far higher returns than investment grade bonds.) An imperfect process Rating agencies stress that their ratings are opinions. Rating agencies stress that their ratings are opinions. Moody s, for example, makes it clear that its ratings are not to be construed as recommendations or the sole basis for investment decisions. 2017 CFA Society Barbados Top 4 3
Moody s, for example, makes it clear that its ratings are not to be construed as recommendations or the sole basis for investment decisions. However, capital markets have come to expect these opinions to be extremely well informed; indeed, investors are literally betting that they are. But at times the rating agencies have come under severe criticism for poor judgment, poor financial forecasting and Also, investors have repeatedly raised the issue of conflict of interest and questioned the objectivity of the rating agencies. for being too slow to spot negative trends. They have also taken heat for being too slow to revise ratings. Such criticism was intense during the financial crisis that started in 2008, when the agencies gave investment grade ratings to complex investment products known as Collateralized Debt Obligations (CDOs). These were essentially packages of sub-prime mortgages, mortgage-backed securities and other forms of consumer debt that were bought in vast quantities by banks, pension funds and other institutional investors, often with few questions asked because of the favourable ratings. When the effect of millions of delinquent mortgages began to ripple up the investment chain these large investors realized that much of what they had bought and thought to be secure was potentially worthless. Investor fury was unleashed on the rating agencies for giving such high credit ratings to high-risk investments that were basically toxic. Such an apparent lack of due diligence on their parts had literally turned their supposed responsibility to investors on its head. Also, investors have repeatedly raised the issue of conflict of interest and questioned the objectivity of the rating agencies. Their point is that the agencies may be tempted to give more favourable ratings than deserved because of the fees they are paid. (In 2008, in a survey of investment professionals carried out by CFA Institute, 11% of respondents claimed to have seen rating agencies upgrading bond ratings under pressure from issuers.) But criticism has come from the other side as well from entities that feel they have been rated too harshly. For example, in 2011 S&P was taken to task for lowering the long-term debt of the US Government from AAA to AA+. It refused to budge even though the Government revealed the agency has made a $2 trillion error in calculating its rating. Moody s has also come under the gun for issuing negative opinions, which the entities involved insisted were not only unwarranted but unsolicited. In other words, the agency wasn t engaged to provide the service; it acted on its own accord to the detriment of the entities involved. Another criticism of the agencies is that their ratings tend to 2017 CFA Society Barbados Top 4 4
lag market pricing of credit. For example, because of perceived changes in creditworthiness, bond prices and credit spreads frequently move more quickly than the agencies change their ratings (or even outlooks) up or down. Bond prices and relative valuations can move every day, whereas bond ratings, appropriately, don t change that often. Even over long periods, however, credit ratings can badly lag changes in bond prices. Clearly, the rating process is imperfect. And to rub salt in the wound, there is no public appeals process against a rating agency. Be that as it may, investors and issuers of debt need the degree of certainty it more often than not provides. Love them or hate them the rating agencies are here to stay. Investopedia and Wikipedia were among sources of material used in this article. Origins of the Big Three The Securities Exchange Commission (SEC) in the United States has licensed 10 Nationally Recognized Statistical Rating Organizations (NRSROs). Of these, Standard & Poor s Financial Services, Moody s Investor Services and Fitch Ratings are known as the Big Three. Another well-known agency is A.M. Best, which focuses on insurance companies. Standard and Poor s accounts for about 42% of the credit ratings business, with Moody s in second place with about 37%. Fitch accounts for about 18%. These three agencies rate tens of trillions of dollars in securities, not only the bonds of corporations and governments but also securitized assets, which are assets that are bundled together and sold as securities to investors. They have been around for well over a century. Although Standard and Poor s was formed in 1941,when Poor s Publishing and Standard Statistics merged, its legacy firms date back to the 1860s and the days of the US railroad boom. In 1966, S&P was acquired by US publishing giant, McGraw-Hill. McGraw Hill became McGraw Hill Financial in 2013 and three years later became S&P Global Inc. Moody s was founded in 1909 under the original name of Moody s Analyses Publishing Company. In 1962, after decades of successful operation, the business was bought by Dun & Bradstreet, the US firm known globally for its ability to supply the credit histories and standing of millions of companies around the world. In 2000, Dun & Bradstreet spun off Moody s Investor Services into a separate publicly listed company. It is now officially a subsidiary of Moody s Corporation. The smallest of the Big Three, Fitch Ratings was founded in 1914 as the Fitch Publishing Company. Over the years Fitch grew steadily through the acquisition of other rating agencies until it was itself acquired by majority shareholder the Hearst Corporation. It was Fitch that introduced the rating system using the alphabet, which was later adopted and licensed by S&P 2017 CFA Society Barbados Top 4 5
This publication is edited by Michael Berry, CFA. Michael is a long-time charter-holder with the Chartered Financial Analyst Institute and currently sits on the board of CFA Society Barbados. He is also President and Chief Investment Officer of Pencarrek Limited, an asset management firm based in Barbados. This publication is produced by CFA Society Barbados, an association of approximately 50 local investment professionals such as portfolio managers, investment advisers and educators. We are a member society of CFA Institute, a global not-for-profit organisation of more than 145,000 investment professionals. Content by Clarity Communication. Design by mgdesignbds.com. 2017 CFA Society Barbados 6