Are Ratings overrated?
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| image credit: HEC Paris (www.hec.edu) |
Globally, bond ratings have been known to drive
liquidity while helping investors take an informed investment decision. These
credit ratings have played a significant role in the decision making process of
purchasers of debt securities while also playing a role in the development of
markets. The International Organisation of Securities Commissions’ (IOSCO)
report on Corporate Bond Markets in Emerging Markets identifies Government
policy and the existence of international credit rating services as
underpinning factors in the general development of bond markets in EMEs,
particularly following bank-based crises.[1]
In spite of the unanimous verdict on the role
played by credit rating agencies (CRA) in the 2007 financial crisis, a role
which many attribute to the conflict of interests by CRAs arising from playing
a dual role of advisory and rating, as well as a lack of competition, the
opinion of CRAs regarding the ability of an issuer to repay a debt obligation
remains a major feature of debt transactions in most financial markets.
In Nigeria, credit ratings are a mandatory
requirement for the issuance of debt securities with the rules of the
Securities and Exchange Commission (SEC) requiring, among other things, that a
rating report should be submitted along with the application for registration.
It would seem from the SEC Rule in question[2]
that where the rating is not of investment grade, the SEC would not register
the debt security which is proposed to be issued.
Assuming without conceding that a rating below
investment grade would not preclude the SEC from registering the debt
securities, IOSCO[3] has rightly observed that
some Investors may operate under guidelines or legal requirements that prohibit
the investor from holding a debt security which is not rated at or above a
certain level by one or more CRAs. This is the case with Pension Funds and
Mutual Funds in Nigeria. With pension
fund assets under management hitting Circa N7.5Trillion in 2017[4]
Pension Funds and Mutual Funds constitute the largest target of issuers of debt
securities. Unfortunately ratings are a huge investment consideration for these
class of investors not just based on investment principles but as a matter of
regulation.
Under the Pension Fund Investment Guidelines;
Pension Funds may only invest in debt securities with a minimum credit rating
of ‘A’. The National Pension Commission further requires this minimum rating to
be maintained throughout the tenor of the investments. If at any time an
existing investment is no longer authorized, as a result of either a credit
rating withdrawal or a credit rating downgrade by more than one grade or for
any other reason, the Pension Fund Administrator has a maximum of 10 working
days to forward its exit strategy to the Pension Commission. In addition, where
a rating expires, the pension fund may only retain such investment for a
maximum of 6 months after the expiration.[5]
While Mutual Funds on the other hand may have
only had Circa 400 Billion Naira under management as at December 2017, analysis
reveals only 8.7% of this figure was invested in Fixed Income Securities in
2017.[6]
This may perhaps also be attributed to the restriction in the Rules of the SEC
which requires that funds received from Retail Investors/Clients and managed
under a discretionary Fund/Portfolio management mandate – whether on individual
portfolio basis or as a pooled Fund - may only be invested in Marketable Debt
Instruments, that is Corporate Debts assigned an investment grade rating and
which has been actively traded for thirty (30) days.
Why then are ratings so important? Ratings are
expected to indicate the credit quality of a bond, having evaluated the
financial strength of an issuer vis a vis its ability to pay a bond's principal and
interest in a timely fashion.[7] However, is a rating really an indication of an ability to
repay?
There have been some defaults by corporate bond issuers in Nigeria
which question the effectiveness of these ratings while also testing the
regulations which make rating a condition for investment by Pension Funds and
Mutual Funds. At the time of issuance, these securities were assigned ratings
of investment grade which probably garnered the interest of investors while
also making them eligible for investments by Pension Funds and Mutual Funds. In
one particular transaction, an investment grade rating was assigned
notwithstanding the observation by the CRA to the effect that earnings and cash
flow underperformance was exerting significant funding pressure on the group.
Naturally, the issuer was unable to meet its interest and principal payments
due to its excessive debt burden, leading to litigation and insolvency
proceedings thereby constraining the rating agency to downgrade albeit still
within investment grade.
As rightly observed by a plethora of authors, Ratings all come
down to personal opinion. Thus, while the information available to a CRA is
also available to investors, CRAs have been known to possess more resources to
facilitate the analysis of relevant information, thereby increasing reliance on
CRA opinions by investors and regulators alike.
The role of CRAs in the development of debt capital markets cannot
be disputed. Ratings provide the much needed liquidity which markets thrive on.
Notwithstanding, corporate events in these markets since 2007 continue to point
to the fact that these ratings may well be overrated. While the jury may be
have been quick to pass a verdict on the role of CRAs in the 2007 global
financial crisis, events post 2007 however seem to indicate that beyond the
identified culprits of Conflict of Interest and a lack of competition among
CRAs, there may perhaps be an issue of overreliance on CRAs and their ratings
by investors and regulators alike even in the face of the bold disclaimers by
these CRAs; An overreliance and prescription which may perhaps have overrated
and rendered these ratings a box ticking activity in certain instances.
[1] IOSCO Research Reports on Corporate Bond Markets in
Emerging Markets https://www.iosco.org/news/pdf/IOSCONEWS401.pdf
[2] Rule 279(2)(r) - rating report by a
registered rating agency (applicable to a debt instrument) the rating of the
Issue and the Issuer shall be of Investment grade and shall be annually
reviewed throughout the life of the bond.
[3] The Role of Credit Agencies in Structured Finance; Pg.
6, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD263.pdf
[5] See Amended Investment
Regulation 2017 – 5.1.6, 5.1.7,
[6] Securities and Exchange
Commission – Net Asset Value and Unit Price as at December 2017 – available on www.sec.gov.ng
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