Why asset managers should ignore credit ratings

May 5, 2009

Jonathan F (a/k/a my boss) wonders whether Goldman’s decision to ignore credit ratings when it comes to bond-investment mandates might not be counterproductive:

The problem with using market prices as a signal for any market action is that it tends to encourage herding by making any market movement self reinforcing. So if a company’s spread widened (or its stock price fell) then investors would react, say by selling its paper, which would then presumably lead to a further credit downgrade. There was a credit agency (it belonged to one of the big ones) that adopted this approach and was blamed for some of the death spirals (or near death spirals) in bank equities in the autumn of 2002 (Commerzbank, etc).

What he’s talking about is a move from the current system, where investors sell bonds which are downgraded to junk, to a new system where investors sell bonds with high credit spreads. Given the choice, the second one seems fairer to me — it means that companies aren’t at the mercy of credit-rating agencies, especially near the crucial triple-B cusp, and it also makes it much easier for the ratings agencies to make that now-fateful downgrade into the Cs.

Taking a bigger-picture view, it can reasonably be said that the ratings agencies, to a good approximation, are basically just lagging indicators for the credit markets anyway. So if you’re going to be exiting certain credits, better you do it sooner, when they gap out, rather than later, when they’re finally downgraded.

It’s also only a minority of corporate credits which really get actively damaged by wider spreads in any case: essentially, it’s the levered companies with a lot of short-term debt needing to be rolled over in the near future. That includes all banks, of course, as well as quasi-banks like GE — but most corporates fund themselves with a mixture of long-term bonds and bank lines of credit, which aren’t nearly as susceptible to market whims.

A move to judging credits based on their spreads rather than their ratings might also help put an end to ratings arbitrage, where companies try to issue debt not where it makes the most sense, necessarily, but rather where they can do so at the lowest cost without damaging their ratings. Essentially the ratings agencies become not a dispassionate observer of how creditworthy the issuer is, so much as a key constituency to be kept in mind when putting any kind of debt deal together. That’s unhealthy, as we saw in the wake of the structured-credit boom. And it should come to an end in the corporate world, too.

But mostly fund managers should stop relying on ratings in any case. They’re both in the business of judging credit: fund managers who outsource that business to a ratings agency are simply not doing their job. And their clients shouldn’t ask that they do so.


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