COLUMN-Cool it with the credit ratings critiques. We need them more than ever: Fridson

By Marty Fridson

NEW YORK, Aug 22 (Reuters) - Lambasting credit rating agencies is a favorite pastime of many debt market participants. However, self-interest appears to drive many of the most common criticisms, and history suggests these much-maligned appraisers actually do a pretty good job.

Credit ratings agencies, such as Moody’s Investors Service, S&P Global, and Fitch Ratings, assign a letter grade to a company or security indicating the default risk. A triple-A rating denotes the lowest risk, while a triple-C rating suggests that the debt in question has a good chance of falling into arrears.

One classic criticism of these agencies is that their assessments are contaminated by a conflict of interest because the bond issuers pay to be rated.

But one will struggle to find any evidence of such bias in corporate bond ratings.

Others might point to the Enron debacle in 2001, when the company was rated investment grade just before it went bankrupt, to suggest that the ratings process must be flawed.

However, the rating agencies make their assessments based on issuers’ audited financial statements, and Enron’s implosion occurred because of the company’s fraudulent financial reporting.

Another common knock is that this reliance on past financial results means ratings agencies, unlike the market, are backward-looking, but agencies’ assessments absolutely do incorporate projections of companies’ future financial results – just like market analysts.

Now, there are valid criticisms of the rating agencies’ assessments of mortgage-backed securities leading up to the Global Financial Crisis of 2007-2009, but those specific concerns do not apply to corporate bond ratings.

SOLID TRACK RECORD

To be clear, neither knowledgeable market observers nor the rating agencies themselves suggest that portfolios should be managed on the basis of ratings alone.

Bond valuations reflect a variety of factors that the rating agencies do not attempt to address, such as maturity, issue size, and short-term supply/demand disruptions.

The rating agencies concentrate their efforts on one highly important valuation factor, default risk. And on the whole, they perform their chosen task quite effectively.

Indeed, Moody’s data covering four decades shows that default rates increase with each step down the rating scale, with a notable jump from roughly 1.4% to almost 8.0% when moving between investment and speculative grade.

So critics may be able to cherry-pick extreme, unrepresentative cases to discredit the rating process, but the historical record suggests that ratings remain a useful input to inform fixed income investment decisions.

SELF-INTEREST

So where does much of the criticism of ratings agencies come from?

First, one often hears griping from investment banks. But they are incentivized to obtain the lowest possible yields for issuers, regardless of whether they compensate investors for the risk. A low rating on a deal is an obstacle to the underwriter’s goal of securing the client’s business by getting the “best” price.

And then there are critiques from bond fund managers, who compete for capital by striving to offer higher yields than their competitors for supposedly comparable risk.

Boosting a fund’s yield above those on competing funds often involves buying securities that the managers claim are “underrated” and thus “mispriced,” meaning they are offering higher yields without an equivalent increase in risk.

But one can only claim to offer a superior risk-adjusted return when dipping into lower ratings buckets if the ratings agencies are genuinely wrong. Otherwise, what the fund manager is doing is simply offering higher yields along with higher risk.

The validity of ratings is especially important for credit investors right now because they are being paid considerably less than usual for taking incremental risk.

For instance, according to ICE Indices, over the period 1997-2024, investors bold enough to increase their risk from the lowest investment-grade category, BBB, to the highest speculative-grade category, BB, were rewarded on average with 143 basis points of extra yield. During this past week, by contrast, the compensation for incurring that additional risk was just around 50 bps.

BALLS AND STRIKES

In the end, it would scarcely be possible to quantify useful risk-reward relationships in the debt market were it not for the letter grades supplied by the much-maligned credit rating agencies.

If fixed income decision-makers instead had to define risk categories and make comparisons all based on market-determined yields, their analysis would resemble a dog chasing its own tail.

Finally, it’s important to note that agencies’ long-run viability depends on investors seeing credit ratings as reliable inputs. That means they actually have a strong incentive to emulate evenhanded baseball umpires and “call ’em as they see ’em,” despite potential pushback from players who hope to shift the odds of victory in their own favor.

(The views expressed here are those of Marty Fridson, the publisher of Income Securities Advisor. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and the Budget, The City of New York).

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