Problems with Credit Ratings and Agencies

problem with trusting credit ratings alone

Credit rating agencies assign credit ratings to corporate bond issues. The ratings reflect the bond issuer’s ability to repay debt obligations on time and in full.

The credit rating scale in India ranges from AAA, indicating excellent financial health, to D, indicating a default/impending default.

And while useful, relying on credit ratings completely to make investment decisions is a bad idea. Here are some problems we see with credit ratings and credit rating agencies.

Don’t incorporate all bond risks

Bonds are subject to multiple risks like:

  • Credit default risk
  • Bond price risk
  • Reinvestment risk
  • Inflation risk
  • Liquidity risk

Even bonds with the highest credit rating can yield low or negative returns if other risks materialise.

For example: Even if you buy a AAA-rated bond, the price of your bond can drop significantly if the interest rates in the market shoot up. This happens because bond prices and interest rates are inversely related.

Hence, a holistic analysis of bonds that goes beyond credit default risk analysis is required.

Conflict of interest

Conflict of interest is the biggest reason why you should probably not rely on credit ratings.

Credit rating agencies are for-profit companies hired by bond issuers to rate their bonds.

Simply put, the bond issuer is a client of the credit rating agency. This creates a serious conflict of interest since the interest of investors gets sidelined.

The bond issuer can simply go to a desperate credit rating agency which promises to give them a higher-than-deserved rating. Under such an arrangement, the credit rating agency gains a client, the bond issuer reduces its interest cost with a better credit rating and the investor is tricked.

Credit rating agencies caused the 2008 Financial Crisis

Credit rating agencies caused the 2008 Financial Crisis. Well, they did not exactly cause it directly but definitely enabled it.

Here’s what happened:

Financial institutions like banks and mutual funds have strict standards on the debt securities they can invest in. Ideally, they can invest in only the highest rated or AAA- rated securities.

Investment banks essentially pooled bad mortgage loans (bad here means unlikely to be repaid) and created new instruments. The Credit Rating Agencies rated these instruments AAA despite being composed of bad loans. They did this to gain clients and revenue.

Borrowers started to default in large numbers, causing the Financial Crisis, which required unprecedented government intervention.

Had the credit rating agencies done their jobs right, they could have discouraged financial institutions from buying bad debt securities and not enabled the Financial Crisis.

Just an opinion

While credit rating agencies publicly disclose their credit rating processes, they admit that their assessment and the rating is just an ‘opinion.’

This makes credit rating a subjective opinion more than an objective and reliable assessment.

It is important to note that even a subjective opinion from an expert is valuable. So, credit ratings, although opinions, carry weight but cannot be considered reliable.

Race to the bottom

Competitive industries are great for the consumer.

For example: If you have 20 soaps to select from, all the soap companies will try to sell it to you. They will improve their product and/or reduce their price to increase sales.

However, credit rating agencies work differently. Since they are incentivised to work for their client (the bond issuer) and not the bond investors, they participate in the race to the bottom.

Simply put, their job becomes acquiring clients by promising them high ratings instead of conducting a genuine assessment and awarding a fair credit rating.

Historic cases of AAA-rated bonds defaulting

Reliance Communication. DHFL. IL&FS. Zee Industries. Amtek Auto (AA).

Credit rating agencies failed to predict the default of these AAA-rated bond issuers. As a result, the credit rating went from the best (AAA) to the worst (D) for these bond issuers.

In the ideal case scenario, the ratings should have moved downwards as financial stress increased at these companies and alerted investors.

But the credit rating agencies were clueless and failed to alert investors resulting in a complete failure of their responsibilities.

If not credit ratings, then what?

Most sophisticated investors know the shortcomings of solely relying on credit ratings. But since there are no clear alternatives of credit ratings, everyone relies on them.

At Dezerv, we do things a bit differently. Our investment team uses a unique PQRS bond assessment strategy. Here is what we do:

We holistically assess bonds across 4 broad factors →

  1. Performance
  2. Quality
  3. Rating
  4. Solvency

This helps us spot financial stress in bond issuers well before they become significantly riskier or reach the point of default.