Role of financial ratings

/ / Portfolio Construction, Traditional

When people hear the leader of a country comment on how a credit rating agency should rate its debt, they realise credit ratings are important. When they read about the role of credit ratings in the global financial crisis, they get angry about the finance industry being responsible for their misery, but figure they must be really important. But when regulators urge mutual funds and investors to not rely on them, I must admit even I was confused. Are they important or not? Are all financial ratings the same?

What are credit ratings anyway?

Before getting into their role, it’s worth explaining what they are. If you were to provide a loan or take an equity stake in your friend’s company, you need to understand the company’s financials, right? When investors want to invest in the debt or equity component of a company or government, they need to know its financials. Since there are millions of investors, it would be cumbersome (actually impossible) for everyone to audit the financial statements or simply the ‘books’. So we get the company to appoint and pay independent auditors to check and verify the accuracy of the financials.

In order to state the financial position, one needs to put a valuation on assets (and liabilities). And this involves some forecasting – which is subjective. So even to state a ‘fact’, one needs some opinions.

Similarly, when making new borrowings, the company appoints a credit rating agency to not only check the financials but also give an opinion the company’s assets are enough to repay any loans it is taking. The financial statements and credit ratings are then made available to equity and debt investors respectively, i.e. the market. Investors rely on these to analyse the ‘fundamentals’ of the company.

Investors form their own opinions on what price they should transact at, based on a range of factors such as their risk appetite, views of the economy and company’s prospects etc. Indeed at any given price somebody is buying so another is selling reflecting their different views.

The points worth noting –

  • The company appoints and pays the auditors and credit rating agencies – both independent agencies
  • Both have access to detailed financials that would be difficult to make available to the market
  • Both verify facts, but also offer an opinion on the company’s ability to repay debt; auditors opine the company can meet its current obligations while the credit rating estimates it can meet its future obligations on the new borrowing
  • Auditors’ opinions are in form of a standard report, with or without qualification, while credit ratings are a scale, with AAA being the highest and anything below BBB being below ‘investment grade’ (on one credit agency’s scale; other agencies have slightly different scales)
  • Both types of firms also offer other services to the companies
  • Investors rely on these facts/opinions but are free to adjust the price they trade at if they don’t believe them

Since credit ratings are considered sign of quality fundamentals, a lot of financial institutions used them as minimum thresholds for investing their portfolios. This means when credit ratings fall, these institutions have to sell that debt from their portfolios. Hence, credit ratings are ‘systemically important’.

Funds ratings are different

On the other hand, fund ratings are completely different from credit ratings in that they are not systemically important, nor do they rely on information that is not available to the public.

For example, research house Morningstar assigns five-star ratings using quantitative calculations based on publicly-available historical performance data. Since it is based on historical data, it can only ever be indicative of past quality. Investors choose to follow them; retail investors do this in droves while institutional investors prefer to conduct qualitative research or rely on global investment consultants like Mercer. Indeed, Morningstar has also started offering forward-looking qualitative ratings, tacitly admitting that star ratings are of limited value.

Either way, fund ratings – quantitative or qualitative – are more like sell-side/broker research – investors can choose to follow the rating or buy/sell opinions based on their view of the provider.

The process for a fund that comes closest to the audit/credit rating process is an operational due diligence (ODD). Neither the retail research houses, nor the global consultants, systematically audit the funds or fund houses to check if they do what they say they do i.e an ODD. Some larger institutional investors do engage specialist consultants to do ODD at their own cost, the results of which are not available publicly. So the question is, are they important? If so, why do retail investors not get access to an independent ODD?

Economic incentives of the ratings business

Now that we have clarified that credit ratings and fund ratings are completely different, let’s look at the economics of their respective businesses.

Credit ratings are mandated. When issuing new debt, companies have to get credit ratings from one of the ‘recognised’ agencies. Hence, there is a ready-made market for credit ratings. The companies pay for the ratings, not the investors. So the agencies don’t have to spend on marketing or convincing investors that they are any good. They only have to deal with ‘rating shopping’ – companies can pay multiple agencies and choose to publish only the favourable ones, or just pay the one that promises to give them favourable ratings.

One would think if the credit rating agencies compromised their ratings enough, their reputation would get tarnished and eventually, they won’t have a business anymore. The fact is that their role in rating collaterised debt obligations leading up to the global financial crisis hasn’t dented their image too much. Hence, credit rating agencies continue to thrive.

On the other hand, the regulators haven’t mandated operational due diligence. While there are compulsory third party reviews of aspects of their operations, these reports are not made available to investors.

As mentioned before, the fund ratings are opinions available to investors – investors can choose to follow or ignore them. Fund ratings vary widely – some are quantitative while others are qualitative. They are more like the thousands of brokers with buy/sell recommendations available to the market. Some do get paid by the fund houses, but they have to do marketing to get a good retail investor following. Others have diversified their business into consulting and funds management.

Conclusion

All ‘ratings’ are not the same – credit ratings and fund ratings are like chalk and cheese. Credit ratings are mandated and provide an audit of facts based on which they base their opinions on the financial viability of the entity. Fund ratings are not mandated and provide no audit of facts; some are simply a statement of history, others merely an opinion on the likely future performance of the funds relative to the market and peers. These two types of ratings should not be compared.

 

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