Corporate bonds are like IOUs; investors essentially lend money to a company in exchange for a fixed rate of return. But how can investors understand whether their money is at risk? Credit rating agencies (CRAs) step in to analyse the company’s accounts, strategies and performance; they give new bonds a rating (score) that flags the bond’s creditworthiness.
The US is dominated by two players: S&P and Moody’s who capture over 90% of market share. However, investors have accused CRAs of being in cahoots with their corporate clients. They say that CRAs inflate their ratings to please their paymasters. High ratings help companies raise financing as well as win the CRA new customers. Yet some research suggests an opposite trend: that firms are receiving more stringent bond ratings, down by a few notches.
I wanted to know more about what exactly was going on. Although the inflation of ratings feels like a conspiracy story, more stringent ratings are just as problematic. Stricter ratings make it harder for corporations to raise finance, which leads to stifled growth and the risk of false warnings damaging a CRA’s reputation.
Market power versus reputation
What pressures on CRAs might influence their final ratings, especially outside of the US where CRA markets are more dynamic? There’s very little research on this question, so I wanted to investigate whether the observed trend towards more stringent ratings was true, and what might be driving this adjustment.
With researchers from Hong Kong and the US, we gathered publicly available corporate bonds data and ratings from 26 high-income countries between 1994 and 2019 to determine trends and associations across time.
We confirmed that overall, bond credit ratings have become more stringent over the years. But we also teased out an important association. Specifically, our results revealed a link between the market power of a CRA (based on their annual country-year market share) and their tendency towards more stringent or cautious ratings. This association was true even when we controlled for different factors, including the 2008 global banking crash.
The association is striking. We found that when CRAs have lower market power, they are more likely give “generous” judgements. We think this may be due to an internal pressure to acquire new clients and increase market share. By giving positive ratings CRAs, companies are more likely to hire them as their rating agency.
Conversely, as a CRA gains market power, it becomes more concerned about reputational risks. Rather than inflated (in favour of corporations), their ratings become tougher and more cautious. The agencies don’t want to overrate a company that later defaults on its bond repayments; this would reflect badly on the CRA’s competence.
Greater stringency does not mean higher quality ratings. We also showed that a more stringent approach had drawbacks too, as it led to more false warnings about companies, known as type II errors.
Prey to pressure
It is important to stress that we show a statistical association between market power and ratings. We did not investigate the mechanisms behind the association and certainly do not suggest that upward or downward rating trends are embedded into a CRA’s rating methodologies in direct response to competitive or reputational pressures.
You’ll always get some variation in credit ratings, because there is subjective judgement and expertise involved. This is healthy.
My prior research suggests these pressures may influence subjective judgements, probably subconsciously. Quantitative analyses are relatively transparent, although even here there is some wriggle room – CRAs rarely take company accounts at face value. However, all ratings require a degree of subjectivity too, by weighting different factors across industries and countries. This may be where the pressures of market power and reputation play out, through a process known as “soft adjustment” based on unquantifiable, sometimes confidential, information.
We did look at other possible explanations. For example, if a CRA has a large market share, perhaps its attract and retains better analysts, or provides better training and quality control. However, our analysis of ratings errors suggests this is not the case. Greater market power and hence stringer ratings did reduce type I errors (failing to identify high risk of default), but increased type II errors (false warnings of default). It’s a double-edged sword.
To validate this association between market power and ratings inflation/deflation, we analysed a natural experiment. In 2006, two local Japanese CRAs were accredited by the US SEC as nationally recognised rating organisations. S&P lost market share in Japan. We clearly show that S&P inflated its corporate ratings after this event, a hint that the inflation of ratings is a response to a drop in market power.
Transparency builds trust
So what do we learn from this clear association between market power and rating trends? For investors, it highlights the old adage: caveat emptor. As part of their own due diligence, investors should keep in mind this influence when they interpret bond credit ratings. Which CRA has high market power? Which is an overoptimistic competitor jostling for position?
Our research is also a call for CRAs to be more transparent.
I think our research is also a call for CRAs to be more transparent, especially on how they use more qualitative data or make soft adjustments. I don’t think the whole process should be standardized – that would be too mechanical and take away the value of analysts’ expertise regarding context. Experts can disagree about things without any kind of fudging or conspiracy!
But perhaps CRAs should publish their methods in more detail and provide commentary to justify subjective judgements. This would also build investors’ trust.
The research leaves us with an interesting conundrum. Given this clear association, should we encourage competition among CRAs? We always think that competition is good, and this is a prompt for many regulators to open up the CRA market. But our research suggests there may be a danger from too much competition. We need enough competition to keep CRAs alert , but not so much that every CRA consistently issues inflated ratings to get market share.
What’s most important is that CRAs are held to account and challenged if their ratings drift too high or too low. Regulators and investors need to be wise to the pressures that CRAs face and ensure they maintain rigor and transparency in their assessments.
