|
|
 |
 |
August 2005 The Long and Short Views of Bond Ratings
Just days before WorldCom went bankrupt, Moody’s rated the firm’s stock “investment grade.” In hindsight, that may sound like the bond-rating system is broken, but in fact, say researchers who recently studied rating systems, the Moody’s rating was appropriate for its specialized clientele. Certified bond-rating agencies such as Moody’s Investors Service serve a
highly specialized institutional clientele with needs that are markedly
different from those of other investors who might rely on the ratings of
non-certified firms, says Business School Professor
William Beaver, who studied
bond ratings with Mark Soliman, GSB assistant professor of accounting, and
Catherine Shakespeare of the University of Michigan Ross School of Business.
Beaver is the Joan E. Horngren Professor of Accounting. Supporters of the system say that certification establishes a high standard of quality for bonds. Others—including members of Congress and, increasingly, representatives of the SEC—argue that the certification requirement serves as a barrier to entry for new competition. Critics also argue that because certified firms collect their fees from the companies being rated, there’s a possible conflict of interest and a weakening of incentives to produce accurate ratings. Non-certified bond-rating agencies appear to respond faster to the ups and downs of the bond market and avoid potential conflicts of interest by collecting fees from investors, not debt issuers. The researchers compared the bond ratings of Moody’s, a certified rating agency, to Egan-Jones Ratings Co, a credible non-certified agency, using three criteria: correlation of their ratings with the stock market; correlation of their ratings with the bond market; and measuring which company led in predicting upswings and downswings in bond ratings. The results were instructive: EJR’s ratings more closely corresponded to both stock and bond market returns and appeared to be more timely and to lead Moody’s ratings by a significant margin in reflecting positive market news. But Moody’s did a better job of reflecting negative news, of explaining non-investment-grade bond yields, and of predicting bond default. This made sense given that there are two distinctly different clienteles for bond-rating information: large institutional investors, many of whom are bound by predetermined “prudent investor rules”; and investors who are more immediately “valuation-oriented” and take a more fluid approach to buying and selling bonds. “Large institutional investors, particularly those governed by prudent investor rules, have contracts that specify the conditions for holding or selling a bond,” Soliman says. “If a bond falls below investment grade, they must sell. The decision is taken out of their hands.” Because of the high costs associated with liquidating bond portfolios, this type of investor doesn’t want the bond rating jumping up and down with each market tremor. Rather, they want the bond rating changes to be more conservative and to reflect long-term expectations about the safety and value of the securities in question. In the stock return test, for example, EJR appeared to change its rating at the same time that new information about a firm was released to the market. To the extent that the market reacts to new information in a timely manner, this suggested that EJR is more responsive to the needs of valuation-oriented investors who rely on its reports to buy and sell securities. But because EJR is so quick to change, its ratings fluctuate far more than Moody’s ratings—something that can actually be costly for institutional investors. For example, EJR more frequently drops bond ratings below investment grade in the interest of perfectly reflecting market dynamics. “Institutional investors can’t handle that kind of volatility,” Soliman says. Both Beaver and Soliman called criticism of Moody’s and S&P’s inability to predict the Enron and WorldCom scandals as “misfocused.” “Over the years, Moody’s has given lots of companies a chance to ‘ride it out,’” said Soliman. “In many cases, Moody’s could argue that, had they downgraded a firm below investment grade, it could have forced premature bankruptcy on the business.” In other words, he said, it’s not unreasonable to assume that the act of downgrading the WorldCom stock had something to do with the firm’s bankruptcy declaration just four days later. “Moody’s isn’t just fulfilling an advisory role; its actions can have negative impact on companies,” said Soliman. —ALICE LaPLANTE |
|
Further ReadingDifferential Properties in the Ratings of Certified vs. Non-Certified Bond
Rating Agencies
|
|
|
 |
|
|
|
The Long and Short View of Bond Ratings
