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Monday, 23 October 2017

Spain just proves the need for homemade credit assessment

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Anthony Peters, SwissInvest Strategist

So Spain got downgraded again – this time by S&P and from AA to AA–. This is how I read it: ” Spain’s credit rating was cut for the third time in three years by S&P as slowing growth and rising defaults threaten banks and undermine efforts to contain Europe’s sovereign-debt crisis…” Now what’s in there that we didn’t already know? What’s more, do we really care?

For many years now, institutional credit risk assessment has been outsourced to the original two and now three leading ratings agencies. But, given the horrific failures of the agencies to get their arms around the risks which led us into the credit crisis, do their opinions still carry weight? More to the point, do their sovereign credit ratings mean anything at all? The answer really should be “no” but it probably isn’t.

In the same way in which Basel III made a rod for its and the banks’ backs with the ratings-based calculation of reserve capital required, so fixed income investment guidelines for institutional investors are also still deeply imbued with agency ratings thinking. We know how equity prices can be affected by the ratings of any one investment banks’ analyst’s change in opinion – how often do we read that “Morgan Parisachs raises XY Corp to buy from hold” and watch the stock price move on the back.

However, in all the years I have been in this business I have yet to see the opinion of a single sell-side credit analyst have any influence whatsoever on the pricing or performance of a credit. At the end of the day, it is the ratings agencies alone who seem to determine at what spread a company can raise money in the public bond markets or where its credit will trade in the secondary.

For all the buy-side credit analysts – and there are plenty of them – it will always be hard for the asset managers to convince their own clients that homemade credit assessment is just as good or better than that provided by the agencies – not because they won’t believe it but by defining the credit profile of an investment portfolio by way of the ratings agencies’ alpha-numeric system is “safe”, uncontroversial and easy to hide behind.

I have often enough pointed my finger at the non-executive directors at many of the banks who knew too little about banking to make a meaningful contribution to defining a proper risk profile for the balance sheet and who found the agency ratings system a quick and easy way to become an instant expert. However, when it comes to some of the amateurs who find themselves on the board of trustees of some of the pension funds, we are in much more complex and dangerous territory.

One must say in defence of the agencies that they can never get it right – if they move pre-emptively, they get accused of creating panic; if they move later, they are castigated for being behind the curve

In an early call with a senior City figure this morning, it was suggested that many institutions now no longer strictly follow the ratings agencies and are, a priori, more conservative in their risk positioning than the formal investment guidelines would suggest. Until last night, Spain was only two notches below Germany’s and France’s Triple A rating, but the spread to German Bunds of more or less 300bp–350bp across the yield curve tells a different story – and the holders of €570bn of Spain’s government bills and bonds can’t all be wrong. However, one must say in defence of the agencies that they can never get it right – if they move pre-emptively, they get accused of creating panic; if they move later, they are castigated for being behind the curve.

Simples

The answer is simple – investors have to wean themselves off the use of boil-in-the-bag agency ratings and begin to assess credit themselves. Investment in credit needs to become a proper bottom-up assessment process again and the game of index jockeying must be kicked into touch. A long time ago I concluded that sell-side fixed income research, be it rates or credit, is never really used by investors but is kept in the bottom drawer to be pulled out if something goes wrong so that the PM in question can retort to his management “… but so and so wrote … and it was very plausible.”

If banks’ balance sheets truly are in the process of shrinking and if corporate borrowers really will have to borrow more through the public markets, then buy-side credit analysis is going to have to become significantly more rigorous – and time will have to be involved – drive-by issuance will become rarer and a higher level of discipline introduced. High-yield markets know how it’s done; investment grade has something to learn.

Alas, it’s that time of the week again. All that remains is for me to wish you and yours a peaceful and happy weekend. May the weather hold for another few days so that your energy may go into the fun of eating rather than up the chimney by way of heating.                                   

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