From the October 2011 issue of Research Magazine • Subscribe!

Do Credit Ratings Matter?

Over the past few years, credit rating agencies have done a lot to diminish their credibility. Not only did they contribute to the Great Meltdown by inaccurately rating debt, but they have allowed the role of credit ratings to become murkier. What do the ratings now mean for financial advisors and clients? 

 AAA in a AA+ Country

Since downgrading the U.S. government’s long-term debt to double-A-plus, Standard & Poor’s has been tripped up by its own scoring system. Four companies retain a higher credit score than the U.S. government: Automatic Data Processing, Exxon Mobil, Johnson & Johnson and Microsoft. Interestingly, this type of thing isn’t supposed to happen, because credit raters employ a “sovereign ceiling” stating that no company can borrow money on better terms than the country where it resides. Yet, triple-A ratings for the four companies mentioned above show the perversity of today’s rating system and how credit raters have broken their own silly rules.

Warren Buffett’s declaration the U.S. deserves a quadruple-A rating may rank as one of the most absurd things said in 2011. Here’s a man who has spent decades evaluating corporate income statements and balance sheets and if any one of these companies he’s evaluated had the U.S. government’s debt burdens or nonsensical methods for dealing with them, it’s a long-shot they would earn a double-A-plus let alone still be in business.

A more accurate view is attributed to Michael Milken, who has been known to point out that sovereign countries have defaulted 30 times as often as private companies, both domestically and foreign. He has stated: “The best credit by far, history has shown, has been the private company.”

Poor Indicators

The most direct indictment of today’s credit rating system is history. Research conducted by the Wall Street Journal analyzing 35 years of data showed credit ratings are ineffective at predicting a government’s risk of defaulting on its debt. Just 12 months before defaulting on their sovereign debt, Russia in 1998 carried a BB-/Ba2 rating. In 2001, Argentina was rated BB/B1 before it defaulted. Each of these grades were six notches above CCC-/Caa3, which is only assigned to debt that’s defaulted with very little possibility of recovery.

Instead of learning from their mistakes, rating agencies perfected them.

In 2007, rating agencies assigned triple-A ratings to approximately 1,300 financial products mostly linked to mortgages. At the time, there were fewer than a dozen U.S. companies with that same pristine rating. Incorrectly assigned ratings facilitated excessive leverage along with slam dunk sales by marketers of garbage debt that would’ve otherwise been impossible to sell. Fitch Ratings, Moody’s and Standard & Poor’s played a key role in triggering the 2007-09 Financial Crisis. Will credit ratings, which remain mostly the same as before, contribute to future meltdowns? 

Regulatory Shakeup

The waning confidence in the accuracy of credit ratings is further demonstrated by major shifts in the regulatory landscape.

In April, the SEC voted unanimously to proposed amendments that would remove references to credit ratings in several rules under the Exchange Act. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act federal agencies must review how their existing regulations rely on credit ratings as an assessment of creditworthiness.

On July 26, the SEC adopted amendments to erase references to credit ratings in the eligibility requirements for the use of short-form registration statements in offerings of nonconvertible debt, preferred stock and also shelf offerings. Prior to these changes, companies were able to quickly register certain securities with the SEC so long as those securities had an investment grade rating by at least one rating agency. However, new standards of creditworthiness have made traditional credit ratings virtually irrelevant.

The SEC has yet to initiate formal policing of rating agencies but is planning to do so with its soon-to-be-launched Office of Credit Ratings. Besides creating more scrutiny on rating agencies, hopefully this shakeup will spur support for alternative methods for credit analysis.

For financial advisors the message is clear: If regulators aren’t relying on traditional credit ratings why should you? 

Impact on Bond ETFs

Many bond ETFs, with the exception of high yield ETFs, have a mandate to only invest in corporate or government bonds with an investment grade rating. What does this mean for bond ETFs? Not much.

Despite the hubbub surrounding the U.S. government’s credit downgrade from triple-A to double-A-plus, there is no immediate impact on the way fixed income ETFs are managed. So long as U.S. Treasuries maintain an investment grade rating, widely held bond ETFs like the iShares Barclays U.S. Aggregate Bond Index Fund (AGG) and the Vanguard Total U.S. Bond Market ETF (BND) will continue to buy and hold them.

It’s also worth mentioning, that Standard & Poor’s was the only rating agency that issued a downgrade. Fitch Ratings and Moody’s Investor Services left their AAA-credit opinion on long-term U.S. debt unchanged.

Rethinking Strategy

Given the poor historical track record of credit ratings, advisors should remain skeptical about building investment strategies around securities or even ETFs that laud investment grade status. Why? Because while an investment grade rating has been traditionally associated with low credit risk, the accuracy of these opinions still remains in doubt. There are many who believe, for example, the U.S. government’s downgrade to double-A-plus still grossly understates the true credit risk of lending money to D.C.

For core bond positions, financial advisors and investors have typically used mutual funds and ETFs like the iShares Barclays Aggregate Bond Fund (AGG), Vanguard Total Bond Market Fund (VBMFX) and the Vanguard Total U.S. Bond Market ETF (BND). But here’s the problem: Around 40 percent of funds linked to this index (Barclays Aggregate U.S. Bond Index) contain exposure to U.S. government bonds and for a core long-term investment holding, that’s probably too much. What’s another alternative?

Instead of using index funds like AGG, BND and VBMFX as core bond holdings, advisors should employ investment grade corporate bond index funds like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) or the SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) as an alternative. Neglecting U.S. government bonds certainly doesn’t jibe with the traditional portfolio management rules of exposure to all asset classes all the time, but extraordinary times call for extraordinary measures.

History, as Milken points out, demonstrates that corporate borrowers are far better creditors than countries or consumers. And if the future apes history, then people who lend their money to prudent corporate borrowers rather than to fiscally drunk countries should fare better.

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