Credit where credit's due

Credit rating agencies, which make pronouncements on the quality or otherwise of bond issuers, wield considerable power in the markets. But the debacle over mortgage-backed securities and sub-prime lending has undermined some of their work.
 
Rating agencies are guardians of credit quality, and because of this their work is highly influential. Their views can have a profound impact on bond prices and yields. They influence the ability of governments and companies to borrow, and the rates of interest they need to offer to attract investors.
 
What exactly are credit ratings? Different agencies use slightly different conventions, but essentially issuers are typically given letter-based codes to indicate their degree of solidity, with AAA being the best and anything with a letter C being regarded as poor, if not indicating a company already in default or filing for bankruptcy.
 
In general terms, the lower the credit rating, the bigger the yield spread that has to be offered over a benchmark government bond with the same maturity. A corporate bond from HSBC (HSBA) (rated AA-) or GE (rated AA+), currently sell on yields around two percentage points more than a government edge stock of similar maturity.
 
The way credit rating agencies like Moody's or Standard & Poor's go about rating bond issuers is rather similar to the way a broker might assess a leading company's shares. In fact, notwithstanding the recent controversy over the role of rating agencies in the sub-prime debacle, their research methods are usually regarded as more rigorous and thorough than the average equity analyst.
 
Equity analysis is different from credit analysis, however, in several significant ways. A credit analyst assesses a company on the basis of its ability to continue paying interest for the term of the bond and repaying principal at the end of the term. It is not interested in any sense in the value of the shares, or whether indeed there would be anything left of equity shareholders in the event of liquidation.
 
Credit analysis focuses much more on cash flow and contractual aspects of the business, rather than on the scope of growth and the ability to pay dividends to equity shareholders.
 
This should be a time when credit rating agencies are in most demand. Defaults on corporate bonds have risen steeply in the last year or so. Companies where there is risk of default tend to have low credit ratings. Credit rating downgrades are often a pointer to potential defaults occurring, or at least a sign that the rating agency is concerned about the financial solidity of the issuer.
 
If debt has increased, industry conditions are deteriorating, or if there is evidence of financial stresses and strains, indicated perhaps by a change of finance director, then a credit rating downgrade might be on the way.
 
Even before the sub-prime implosion, credit rating agencies faced their share of criticism, partly because they are essentially unregulated self-appointed guardians of the market, albeit ones with a long and distinguished history.
 
One criticism is that they try to strong-arm companies into paying for a full rating. On occasion one of the agencies will issue a rating on an unsolicited basis, the implication being that, if the company were to co-operate and pay for an official rating, it might get a better one. Some cash rich companies might not be contemplating bond issues, but nonetheless might be forced into paying for a rating they don't require.
 
Credit rating agencies are also in effect a duopoly. Although there are a number of other smaller rating agencies that operate in the market as well as Moodys and S&P, these two big institutions are dominant in the market.
 
Another criticism the agencies face is that their approach is too inflexible and formula-driven and that their staff on occasion may be inexperienced. It may have been this aspect that led to their giving the special purpose vehicles issued by sub-prime lenders and their associates a considerably higher rating than was warranted by the underlying assets and their quality.
 
This is not a new problem. There have been examples in the past of rating agencies overlooking distinctive facets of a particular industry, which objectively might eventually prove to have a major bearing on the rating.

Peter says

Effective regulation of credit rating agencies is hard, and may not even be necessary or desirable.
 
It is probably fair to assume that the rating agencies have learnt from the lessons of the sub-prime crisis, in particular the way in which their own analysts may have been lulled into thinking, as many investors also did, that the vehicles that held mortgage backed securities were rather more solid than they seemed.
 
It is also worth noting that credit rating agencies produce research that is detailed and of high quality, certainly compared with some of the research put out by equity brokers. It focuses on the aspects to which equity investors might do well to pay more attention. Finally, deteriorating credit ratings on a corporate issuer are also a signal that should be heeded by actual and potential investors in the shares of the company concerned.
 
If bond rating agencies are worried about an issuer, it is well worth equity investors treating the shares with a degree of caution, or at least pondering further on the nature of these concerns.