If misery indeed loves company, then you might find the following to be a heartwarming tale. For, you see, regular people aren’t the only ones who have had an awful 2020. Credit ratings agencies (companies that assign ratings to government and corporate debt securities based on their perception of the issuers’ ability to pay interest and principal) have taken their lumps, too. First they downgraded Canada and the UK and … few commentators that we follow paid them much mind. Then they downgraded two Australian states, and some Aussie financial commentators responded by rhetorically downgrading the agencies in noting just how feckless these ratings have become. We aren’t reveling in anyone getting (metaphorically) kicked in the teeth. But we think it is noteworthy that the world is catching on to the meaninglessness of ratings changes—illustrating how much the world has moved on since Standard &Poor’s (S&P) downgraded the US’s credit rating nearly a decade ago. It gives investors one less thing to fear.
Once upon a time, conventional wisdom amongst financial commentators held that if one of America’s three Nationally Recognized Statistical Ratings Agencies (NRSROs) downgraded a government’s credit rating, it would trigger mass selling of that issuer’s debt, sending interest rates soaring as investors fled the allegedly heightened credit risk. That was the raging fear we observed when S&P downgraded the US’s credit rating from AAA (the highest possible rating) to AA+ on 5 August 2011. At the time, the 10-year US Treasury yield was 2.58%, relatively low compared to history.[i] But the downgrade didn’t trigger a sudden disruption in financial markets. Pension funds and overseas governments (cough, China) didn’t dump their holdings en masse.[ii] Yields did not soar. Instead, they fell. One month later, America’s 10-year yield was down to 1.98%.[iii] A year after the downgrade? 1.59%.[iv] Now, the 10-year all the way down to 0.9%.[v] In the interim the US has had no debt crisis and seemingly no trouble finding buyers for new debt, despite quite a bit of new issuance. Other nations receiving downgrades in this era, including France, the UK and a host of other stalwarts, could tell similar tales.
None of the downgrade chatter we have observed since 2011 has matched the panicky hyperbole we saw then, but we have still seen a fair amount of fear—particularly when the UK faced another round of downgrades after the Brexit vote. This year, however, downgrade chatter seems largely absent amongst financial commentators we follow, and in our view, for good reason. It has always been our opinion that the NRSROs—which include S&P, Moody’s and Fitch—based their decisions on backward-looking information, which our research indicates markets incorporate well before it becomes part of an NRSRO’s report. For instance, in 2011, S&P’s stated rationale for downgrading the US was Congress’s protracted battle over raising America’s debt limit—a debate that had ended three days prior.[vi] Investors had spent months dealing with panicky headlines and shouting politicians. Markets, which our research shows deal efficiently with widely known information, reflected all of it—including the many popular rumours of S&P’s impending decision. The announcement merely tied a bow on everything, adding S&P’s official opinion to the many, many, many opinions we think Treasury yields had already priced in. Investors then seemingly decided they were perfectly capable of weighing risks on their own and acting accordingly, and they continued buying, sending yields lower.
Downgrades haven’t become more momentous for yields in the annus horribilis known as 2020. Fitch downgraded Canada on 24 June, when Canada’s 10-year yield was 0.55%.[vii] It is now 0.74%, mirroring rate rises in the US and other nations that weren’t downgraded this year.[viii] More recently, Moody’s downgraded the UK on 16 October. That day, 10-year gilt yields closed at 0.17%.[ix] Since then, they have risen all the way to 0.26%—a move also paralleling most major developed markets.[x]
Rating sovereign issuers isn’t the NRSROs’ only job. They also rate corporate debt, and here, we think things get even muddier due to the business model. Corporations pay the rater, which means three for-profit ratings agencies are competing for business. This model, known in the industry as issuer pays, gives the rater a financial incentive to offer a more favourable rating, lest the issuer not like a tough rating and decide to take their business elsewhere. Many commentators we follow blamed issuer pays for inaccurate credit ratings during the 2008 – 2009 financial crisis, and we think the problem hasn’t really gone away despite regulators’ many attempts to fix it. As one astute commentator summed it up Monday: “Just as the scandal surrounding the collapse of Enron in 2001 led to the demise of its auditor, Arthur Andersen, formerly the big public accounting firm with its nose highest in the air, so the financial crisis showed the world that when one for-profit business is paid to report on the affairs of another for-profit business, only an innocent would expect the audit or prospectus report or modelling exercise or credit rating to be genuinely independent.”[xi]
A grand irony to note here is that just as commentators seem to be paying less heed to raters’ views, the huge raft of bond issuance in 2020 is great news for their bottom lines. The fact ratings are enshrined in global financial regulation means that even when people mind them less, they won’t go away.
We don’t see any immediate market-related takeaways from this, but we find the evolution in sentiment noteworthy all the same. As more people catch on to NRSROs’ faults, it likely improves the world’s general understanding of how markets work—always and everywhere a good thing, in our view. (Provided this understanding sticks over time.) It likely also inspires investors to look increasingly beyond raters’ grades and do their own due diligence, which we think increases awareness and likely helps the market price securities even more accurately. Perhaps most importantly in our view, as downgrades lose their hold over sentiment, it gives investors one less false fear to deal with.
[i] Source: St. Louis Federal Reserve, as of 15/12/2020. 10-year US Treasury yield (constant maturity) on 5/8/2011.
[ii] Source: US Treasury, as of 15/12/2020.
[iii] Ibid. 10-year US Treasury yield (constant maturity) on 6/9/2011.
[iv] Ibid. 10-year US Treasury yield (constant maturity) on 6/8/2012.
[v] Ibid.10-year US Treasury yield (constant maturity) on 14/12/2020.
[vi] We will let you decide whether this rationale really was behind the downgrade or the firm’s maths, which included a widely acknowledged, multi-trillion dollar error.
[vii] Source: FactSet, as of 15/12/2020. 10-year Canada benchmark government bond yield on 24/6/2020.
[viii] Ibid. 10-year Canada benchmark government bond yield on 15/12/2020.
[ix] Ibid. 10-year UK benchmark government bond yield on 16/10/2020.
[x] Ibid. 10-year UK benchmark government bond yield on 24/6/2020.
[xi] “Beginning of the End for the Ratings Agencies’ Dubious Influence,” Ross Gittins, The Sydney Morning Herald, 14/12/2020.
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