Analysis: Large investors leave debt rating agencies behind

By Kevin Plumberg and Claire Milhench

HONG KONG/LONDON (BestGrowthStock) – When Fitch raised Indonesia’s credit rating in January to just one level below investment grade, debt strategist Anthony Chan took little notice.

That’s because an internal model used by his firm, U.S. asset manager AllianceBernstein, had raised Indonesia’s debt rating to the equivalent of investment grade more than a year earlier.

“The big difference is we incorporate a lot of our own forecasts into our model,” said Hong Kong-based Chan. “I am not too sure how many forward-looking elements the credit rating agencies use.”

Since the global financial crisis, agencies such as Fitch Ratings, Moody’s Investors Service and Standard & Poor’s have come under fire for being behind the curve. They failed to sufficiently predict the crisis or, two years later, the debt problems in southern Europe, critics contend.

For many active asset managers, the problem with the ratings companies is not that they are too slow to spot trouble. They are just too slow.

That is why large investors are relying more on their own proprietary rating systems and less on ratings agencies’ actions, which means they often spot investment opportunities ahead of other investors who rely on the ratings set by the agencies.

INEFFICIENCIES

Bill Gross, the outspoken managing director of PIMCO, the world’s biggest bond investor, highlighted the mismatch in a newsletter last month.

Ratings agencies “no longer serve a valid purpose for investment companies free of regulatory mandates” that are nimbler than the S&Ps of the world, he wrote. In November 2009, the U.S. state insurance regulator hired Gross’ firm to reassess mortgage risks in the nation’s insurers because of the ratings agencies’ shortcomings.

Jamie Stuttard, head of European and UK fixed income for Schroders in London, is one such nimble investor who saw the debt problems building up in southern Europe.

Even though Spain has Moody’s top rating, suggesting its debt carries little or no risk of default, Stuttard believes its ability to pay coupons and principal in the next five years is probably lower than junk-rated issuers such as healthcare conglomerate Fresenius or Heidelberg Cement.

So, Stuttard has been 40 percent underweight southern European government debt for the past year, a bet that has proved to be lucrative.

The Bank of America-Merrill Lynch Spanish government bond total return index is up 0.5 percent from 12 months ago, while the European Union government bond index is up 7.6 percent.

“We like the fact that the European market is highly inefficient and there are stale, prevailing views of what is risky and what is not,” he said.

Jonathan Platt, head of fixed interest for Royal London Asset Management (RLAM), says researching a bond rather than depending on ratings agencies can reveal attractive opportunities.

“We are not under pressure to sell bonds when they are downgraded to sub-investment grade, and that has provided some good opportunities,” he said, citing Britain’s second-biggest pubs group Enterprise Inns, which it bought for 60 pence in the pound after the company was downgraded.

He will also look at bonds from companies not rated by the agencies, such as British property and transport firm Peel Group, whose property unit is restructuring debt. Peel’s 30-year bonds are offering yields of 8.5 to 9 percent, Platt said.

Similarly, the secured bonds of housing association Peabody Trust have been unrated since mid-2009.

“At their current yield level of some 1.75 percent over gilts we believe this is exceptional value for a bond where risk is significantly mitigated by structural protection and by a claim on assets,” said Eric Holt, head of credit at RLAM.

Fund manager Franklin Templeton uses credit spreads rather than just debt ratios so that its internal risk assessment system is more forward looking.

Credit default swap spreads are a market-determined measure of credit risk that usually react faster to events than ratings actions, the firm said in a presentation to clients.

The risk model also takes into account implied volatility for where there is a liquid derivatives market and forecasts potential volatility.

The ratings agencies themselves contend markets are fickle and instruments such as CDS are used to hedge a number of different risks beside debt exposure. Consistency in their method of rating debt is paramount.

POINT OF REFERENCE

The internal credit ratings system of MFS Investments, says chairman Bob Pozen, means his firm can quickly change its mind, unlike other investors who might rely on the slower moving rating agency decision.

“Their view is they can’t change a rating until the objective evidence becomes compelling. We look at objective evidence but also trends and market judgments,” said Pozen, whose firm oversees nearly $200 billion in assets.

Although a critic of ratings agencies, Pozen says they serve an important role as a longer-term reference for investors.

Indeed, Max Wong, institutional business director with Franklin Templeton in Hong Kong, said financial markets still react sharply at times to ratings actions, so fund managers have to react in turn.

Last week, European Central Bank board member Christian Noyer criticized ratings agencies for not spotting debt problems quickly enough before they arise. Added to which, they exacerbate market volatility when they do finally act.

“The fact is a lot of the institutional investment guidelines are still built around the ratings system,” said Wong. “There would be chaos without any after-the-fact measurements.”

So while some investors are relying less on the well-known alphabetical announcements from the ratings firms, the so-called agencies still serve a purpose as a kind of signpost seen through the rear-view mirror of a fast-moving car.

Stock Analysis

(Editing by Neil Fullick)

Analysis: Large investors leave debt rating agencies behind