If there was any question about it, the financial crisis of 2008 demonstrated to us all just how flawed the ratings process is, where AAA debt was suddenly in default and highly rated companies all of a sudden required bailouts seemingly overnight. However in the aftermath, while there have been efforts to reduce our reliance on ratings, it has also become clear that changing the ratings process is exceedingly difficult, if not impossible. They are ingrained in our system and ingrained in the way many people and institutions invest.
As we have previously discussed in our piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market,” we see several problems with credit ratings:
Investors should understand what the ratings agencies themselves say about their ratings. Among their various disclosures, the ratings agencies caution that their ratings are opinions and are not meant to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security. So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 25+ years. We see the ratings agencies as reactive not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions.
Peritus views credit as either “AAA” or “D” and places limited value on the rating agencies and their methodologies, which we see as backward looking, reactive, and lagging the market perception of risk (e.g., Worldcom, Enron, Lehman, AIG). Peritus believes that many fixed income investors continue to use ratings as one of their primary investment tools, which we believe ultimately creates inefficiencies and opportunities in the high yield market for active managers. For instance, some institutions have policies whereby a security is automatically sold once it is downgraded to a certain level. The problem is that by the point, if there are issues, the market has generally already recognized them and taken the security price down. And vice versa with ratings upgrades. So, investors waiting to take action based on ratings moves would have likely already missed the boat to either sell at a higher price or buy at a lower price.