Dec 08

Bond buyer's tip: Be careful with credit ratings

Alec Klein recently wrote a multi-part series on credit rating agencies in the Washington Post (Nov 22 to Nov 24).  It is an excellent article, well researched, and full of investigative nuggets that investors have suspected for some time.

In all, Klein suggests that the big three rating agencies ---
S&P, Moody's and Fitch --- are market powers best handled gingerly
and warily by companies.

As an example, Klein delivers the blow-by-blow account of the way
Moody's went about rating Hannover Re, the large German insurer.
Having been rated by two other rating agencies, Hannover did not want
to cut the check for a Moody's rating.  Notwithstanding their refusal,
Moody's went ahead and rated Hannover anyway, effectively providing an
"unsolicited" rating. 

Last year, while other raters gave Hannover good ratings, Moody's
cut Hannover's debt to junk status, triggering massive selling of
Hannover shares and a loss of $175 million that day in market value.

Is it a shakedown?  After all, this is real money. The raters have
every incentive to get the borrowers to pay up, including the use of
the "unsolicited" ratings club.

And the business is huge.  According to Klein, Moody's now rates
more than 150,000 securities, 23,000 borrowers and reported last year
revenues of $1.25 billion.  Through a fee schedule obtained by the Post, Klein noted that rating costs are between $50,000 to $300,000 for corporate borrowers. 

As a retail investor, you should perhaps keep this in mind about the raters:

1.  Unsolicited ratings add little to what is already known about a borrower.  The raters have developed information from public sources --- i.e, nothing that you haven't already seen.

2.  Defaults on good quality bonds are relatively low in the market.
In a Moody's study of corporate bond ratings from 1970 to 2001,
Aaa-rated bonds defaulted 0.1% while lesser quality Baa-rated bonds
defaulted 1.6% in the period.  Once in the province of below-investment
grade bonds, the default rates escalate.  Be careful about imprudent
investing there.

3.  That said in #2, the rating agencies have definitely been laggard
in catching the big defaults --- among others, Enron, Worldcom and
Parmalat.  Despite all their insider access (granted by government
fiat), the big three still missed the defaults that caused the most
investor pain. 

Why?  Because the credit rating agencies are not auditors.  You need
to keep that in mind.  If fraud is the reason for a default --- and it
appears to be a large reason for the defaults since 2000 ---then the
credit rating will not do much good.   The credit ratings are only as
good and reliable as the financial statements are valid.

4. Lastly, more ratings will not mean a stronger credit,
too.  Companies are obliged to get two or three ratings to satisfy
their institutional investors.  Many large funds require at least two
solid ratings for their investment committees.  Given the point made in
#3, it's hard to say if a Moody's rating trumps a Fitch rating or not.
Different investors will likely have a different view.

If you're worried about defaults, here are two quick tips for the retail bond investor.

1.  Stay with solid investment-grade credits.  As you can see from the default probabilities, the better the credit, the less likely the default.

2.  Check out bonds that adjust their coupons for credit downgrades.
Interestingly, companies like Wyeth and Deutsche Telecom (and others)
have issued bonds that compensate the investor for downgrades. 

For instance, the Deutsche Telecom Intl Finance 8.5s 6/15/2010
(Baa1/BBB+) steps up in coupon by 50 basis point for each rating
downgrade below the single-A level  (and vice versa, for a ratings
upgrade).  It was interesting too that against similar credits, the DT
bond seemed to be trading in line.  That is, the retail investor is not paying up too much for this feature.