Evaluating The Bond-Rating Agencies

A bond rating is an assessment of the default risk of a bond by an independent private agency. The ratings do not reflect other risks, such as interest rate risk, associated with investing in bonds nor are bond ratings recommendations to buy or sell particular bonds. They are specific to the quality of a particular debt issue. Companies in poor financial shape can issue highly rated debt, for example by securing that debt against valuable assets or through third-party credit enhancement.

Ratings are a convenient label for the default risk of the bond, particularly for many regulatory and legal purposes. However, academic research demonstrates that they are more than a convenient label. Rating agency decisions convey information to the capital market, probably because the agencies have access to confidential data about an issuers financial health and prospects.

Major players

Bond ratings were first published in the US by John Moody in 1909 and had their origins in the credit evaluation process developed by Dun and Bradstreet.

Ironically, John Moodys company was acquired by Dun and Bradstreet in 1962.

There are now four big providers of bond ratings for publicly traded debt in the US: Standard and Poors (S&P), Moodys Investors Service, (Moodys), Fitch Investors Service (Fitch), and Duff and Phelps Credit Rating Company (Duff and Phelps).

S&P and Moodys have the dominant share of the US market, split almost equally between them. Big players outside the US include: Australian Ratings (now owned by S&P), Canadian Bond Rating Service, Dominion Bond Rating Service (Canada), Japan Bond Research Institute (JBRI), Japan Credit Rating Agency (JCR), Nippon Investors Services (NIS), Agence dEvaluation Financiere (ADEF, a French agency now owned by SP), Thai Rating and Information Service (TRIS) and Rating Agency Malaysia (RAM). Ratings for debt that is not publicly traded are provided to institutional clients by the larger players and by boutique organisations but are seldom disclosed publicly.

Other rating agencies specialise in the banking and insurance industries. For example, AM Best Company rates the claims-paying ability of insurance companies and Thomson Bankwatch and International Bank Credit Analysis (IBCA) in the UK rate the creditworthiness of a variety of obligations of banks and financial institutions. Although the bigger rating agencies have introduced similar bank and insurance rating products, the specialists dominate those industries.

Rating agencies assign debt issues to discrete risk categories and label those categories with letters. Table 1 lists the letter grades used by the big US agencies together with the summary interpretation given by S&P for each rating category or class. The industry has virtually standardised on the letter grade rating system employed by S&P. Fitch first used these symbols, a variant on John Moodys symbols, in 1922 and sold the rights to the symbols to S&P in 1960.

Debt rated BBB and above is classed as investment grade. Originally, debt below BBB was classed as speculative. Since the early 1980s that debt has been labelled junk, a marketing faux pas that rivals the most notorious consumer marketing gaffes. The term high yield is slowly replacing the pejorative junk label.

The investment-grade label has considerable significance from a regulatory standpoint, especially in the US and Japan. For example, many US financial institutions are allowed to invest in investment-grade securities only.

Table 2 lists some US regulations that rely on security ratings. In addition, state laws and legal precedents restrict the investments of trusts and fiduciaries to investment-grade securities.

Most of these laws and regulations require that the rating be given by a Nationally Recognised Statistical Rating Organization (NRSRO), a designation bestowed by the Securities and Exchange Commission (SEC). The NRSRO designation process is somewhat mysterious and considerably frustrating for non-US ratings agencies. There are no formal criteria for the designation and it is alleged that applications from several non-US rating agencies have been in limbo for several years.

Each of the four major US players is an NRSRO IBCA and Thomson Bankwatch are NRSROs for a restricted set of securities, essentially those issued by banks and financial institutions. Similar designations are made in other countries.

Each of the rating agencies has extended its product range to provide ratings on a wide range of fixed-income products extending from short-term commercial paper to structured finance transactions. Although the rating scales often differ from the letter grades used for the standard bond ratings and, for some products (for example counterparty risk and claims-paying ability), the issuer, not the issue, is rated. Table 3 lists some of those products.

The rating process

The rating agencies provide an initial rating for a debt issue and monitor that issue during its life. Rating agencies base their decisions, in part, on publicly available data about the issue, the company, the industry and the economy. In addition, most agencies visit the business, interview key managers and obtain private information about performance, budgets, plans and forecasts.

Some rating agencies employ statistical classification models, although ultimately, the rating is a judgment based on quantitative and qualitative data.

Most agencies give the organisation advance notice of a proposed rating or proposed rating change and allow management an opportunity to respond. The ratings and rating changes are carried by financial newswires such as Reuters and PR Newswire, displayed on trading screens (such as Bloomberg and Telerate), reported in regular publications of the agencies and reviewed in the financial press.

Originally, rating services derived their revenue primarily from fees charged to subscribers to the rating bulletins. Now the revenues of US agencies come almost entirely from fees charged to the issuer of the security, although subscription fees are still important in some other markets outside the US.

Typical issuer fees include an initial fee based on the size and complexity of the issue, together with monitoring fees. Both S&P and Moodys have a policy of publishing ratings for all large corporations with significant outstanding debt, even if the issuer does not solicit the rating. Presumably, these unsolicited ratings enhance the comparability of solicited ratings.

Some controversies

The 1970s were difficult for the rating agencies. Criticism came from politicians, issuers and investors and the rating agencies were threatened with government supervision. The agencies are always tempting political targets for politicians from cities and districts that face higher borrowing costs as a result of an unjustified (in the politicians view) bond rating downgrade. For example, the New York City financial crisis in the 1970s placed the agencies in a predicament. At one stage, S&P suspended the ratings on city debt and was vilified for causing, or at least exacerbating, the subsequent financial chaos. On the other hand, Moodys retained its A rating (perhaps attempting to counteract its me too image). The bonds eventually defaulted and investors criticised the relatively safe rating assigned by Moodys.

In another example, the Australian government forbade any contact with Moodys after losing its AAA rating in 1986.

Other spectacular financial collapses led to accusations that the agencies respond to bad news too slowly, perhaps out of concerns for the issuer who pays the rating fees. The most often cited examples of the alleged tardiness involve two instances where prominent companies (WT Grant and Penn Central) declared bankruptcy when their debt was highly rated and that of the real estate investment trusts and insurance companies in the 1970s. In the latter case their ratings were not changed until they experienced severe financial difficulties.

The corporate restructuring wave of the 1980s brought home a limitation of bond ratings that, although freely acknowledged by the agencies, had been ignored by many investors. Bond ratings do not reflect the vulnerability of the bond to what is known as event risk extraordinary changes in the financial or operating characteristics of a business.

For example, some bonds are poorly protected by covenants. The default risk of those bonds changes dramatically if a company takes on massive quantities of additional debt or if it is acquired by a much riskier business. In several highly publicised instances, holders of highly rated debt experienced large losses when these events occurred. Despite disclaimers by the rating agencies, many critics attributed these losses to inadequate investigation by the agencies.

Similarly, the financial engineering innovations of the 1990s created securities with complex option-like features (such as mortgage-backed securities and their components) whose value could fluctuate dramatically even if their default risk was minimal.

Currently, the antitrust division of the Justice Department is investigating the ratings industry for evidence of anti-competitive practices, apparently focusing on the issuing of unsolicited ratings.

Recent developments

In response to some of the criticisms, the rating agencies have greatly expanded their staffs, adopted new technology, worked at improving the timeliness of their ratings and stpped up their public relations efforts. In particular, in 1981 S&P introduced Credit Watch, which provides an early warning of a rating revision. Other major rating agencies quickly followed with similar services. All of the large agencies now have electronic services that notify subscribers of potential and actual ratings and revisions.

The rating agencies have expanded not only the range of claims they rate but also, in response to criticisms discussed above, the types of ratings they issue. For example, S&P now issues supplementary ratings about event risk, designated E1-E5. These ratings are based on an analysis of the protection afforded by covenants, collateral and other contractual features of the issue (such as a put feature). They reflect judgement about an issues susceptibility to loss if a deleterious event occurs but not the likelihood of such an event happening.

As public debt markets developed and expanded outside the US, S&P has grown internationally with an aggressive acquisition and affiliation strategy and both S&P and Moodys have opened local offices throughout the world. Foreign rating agencies have not penetrated the US market to any great extent, perhaps reflecting the barriers created by the NRSRO certification process.

Performance evaluation

Evaluating the performance of rating agencies requires an appreciation of their economic purpose. In principle, the agencies have at least two roles: information processors and certifiers.

The first role is primarily market driven the second is primarily driven by regulation.

If there are economies of scale and special skills or training associated with information gathering and processing, rating agencies can reduce search costs by providing investors with information about the default risk of bonds, just as restaurant guides can provide value to discerning diners.

Moreover, published debt ratings reduce the information costs of others who contract with an organisation (such as suppliers, customers and employees) and are concerned about the companys financial health. In particular, ratings can reduce the costs associated with evaluating counterparty risk in over-the-counter derivatives transactions.

Certification demand is driven by laws and regulations that restrict the investment behaviour of financial institutions, such as those described in Table 2. Certification demand is partly market driven because it reduces the cost of writing contracts by providing a convenient summary statistic (the bond rating, akin to a restaurants rating in the Michelin guide.) For example, security ratings allow a corporation to restrict the behaviour of someone in charge of short-term cash management to investing in securities with at least a given rating.

Academic research has emphasised the information content of bond ratings, the accuracy of bond ratings and the extent to which ratings can be predicted with publicly available information.

Timeliness of the information is more crucial with regard to information than for certification. Rating changes provide information to investors only if that information is not already incorporated in the price of the security. Research demonstrates that the announcement of a rating change for the debt of an organisation affects the price of the debt and the companys equity. The effects are stronger for downgrades than for upgrades, though the effect is relatively small (less than 2 per cent of the market value for the two-day period around the announcement).

Furthermore, the rating changes follow much larger changes in the price of the security, suggesting that much of the information leading to the rating decision is incorporated in the securitys price by the time the change is announced.

Of course, if it were not for the looming presence of the rating agencies, some of that earlier information might not be released as quickly. Does this mean that the agencies act too slowly? Research has yet to answer that question because the optimum speed of action depends on unknowns such as the costs and benefits of gathering and disseminating information more rapidly.

However, competition among rating agencies should provide incentives for the agencies to provide more timely information if it is cost effective. Some of the innovations such as Credit Watch and the increased use of electronic dissemination of rating changes are examples of agencies reacting to their perception of market demand.

The accuracy of bond ratings has been addressed by studies of bond yields and returns. Yields on bonds are highly correlated with bond ratings. Yields vary within rating classes, providing evidence that investors do not accept ratings mindlessly, though there is not enough evidence to address the question thoroughly.

Conclusion

Actual returns on bonds strongly support the view that ratings provide reliable implicit assessments of the probability and magnitude of default.

The track record for lower-rated investment-grade bonds, though, has been documented conclusively only recently and the rate of return earned by junk bonds remains an open question, primarily due to data limitations.

Academic research demonstrates that bond ratings can be predicted with a high degree of accuracy with publicly available data, leading some to question what value the agencies add beyond certification.

However, most researchers now conclude that bond yields are associated more strongly with ratings than with publicly available data alone, implying that the agencies provide additional information, perhaps as a result of their contacts with management.

The alleged monopoly power of the rating agencies is difficult to substantiate.

S&P and Moodys have dominant shares of the US market, as do successful businesses in many markets, especially if there are economies of scale. In the US, Moodys and S&P compete for new business and both Fitch and Duff and Phelps aggressively seek market share and introduce new products and services. The niche companies maintain large market shares in their areas of specialisation, despite attempts by the big players to invade their turf.

Outside the US, there are strong independent competitors in some of the large markets such as Japan and the UK but S&P and Moodys have made some inroads.

Ironically, there is a barrier to entry in the US market, the NRSRO label, and that barrier is created by regulators. No such barrier exists for organisations ranking mutual fund performance and a vigorous new entrant (Morningstar) has revolutionised that industry. Such a revolution is unlikely in the bond rating industry given the regulatory barrier.n