The North American Securities Administrators Association is warning investors to “be wary of bond ratings” because inflated ratings, which were a key factor in the 2008 financial crisis, remain a concern today.
Investors “should look beyond” a credit rating “when considering investing in a specific bond of bond fund portfolio,” according to the NASAA advisory.
“Ratings agencies are being paid by the companies issuing the debt, so they have a big incentive to give favorable ratings to the company or underwriters will continue to come back,” notes the NASAA advisory. “Because of these and other shortcomings, ratings should not be the only factor investors rely on when assessing the risk of a particular bond investment.”
The payment model for ratings agencies has not changed despite the role that the agencies played during the financial crisis and the requirement in the Dodd-Frank Act the followed for the SEC to recommend an alternative business model for those agencies whose ratings could be used by companies for regulatory purposes.
According to the Financial Crisis Inquiry Commission, the three leading ratings agencies, Moody’s, S&P and Fitch, were found to be “key enablers of the financial meltdown … The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval … Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”
Increased competition among rating agencies also hasn’t ended ratings inflation but rather contributed to it.
An August 2019 Wall Street Journal analysis of about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019 found that increasing competition in the ratings market, which was expected to improve the quality of bond ratings, has failed. The newer ratings firms like DBRS, Kroll Bond Rating Agency and Morningstar, tended to dispense higher ratings than more traditional ratings agencies like Moody’s, S&P and Fitch, according to the Journal’s analysis.
Fixed income issuers also are sometimes at fault because they “use complex and unreliable models to the probability of default” which can cause rating agencies to give a higher than rating than they should, according to NASAA.
It recommends that investors interested in purchasing bonds ask questions and contact their state or provincial securities regulator first as part of their due diligence homework before making their investment decision.
— Check out Sen. Warren Wants the SEC to Crack Down on Inflated Bond Ratings on ThinkAdvisor.