If misery indeed loves company, then what follows should be a heartwarming tale. For, you see, all of us normal people aren’t the only ones who have had an awful 2020. Credit ratings agencies have taken it on the chin, too. First they downgraded Canada and the UK and … few noticed. Then they downgraded two Australian states and pundits responded by rhetorically downgrading the agencies in noting just how feckless these ratings have become. Not that we are reveling in anyone getting kicked in the pants, 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 S&P downgraded the US nearly a decade ago and giving investors one less thing to fear.
Once upon a time, conventional wisdom held that if one of the three Nationally Recognized Statistical Ratings Agencies (NRSROs) downgraded a government’s credit rating, it would trigger mass selling of that issuer’s bond, sending interest rates soaring as investors fled the allegedly heightened credit risk. That was the raging fear when S&P downgraded the US’s credit rating from AAA to AA+ on August 5, 2011. At the time, the 10-year US Treasury yield sat at a benign 2.58%.[i]But the world did not end. Pension funds and overseas governments (cough, China) didn’t dump their holdings en masse. Yields did not soar. Instead, they fell. One month later, the 10-year was down to 1.98%.[ii] A year after the downgrade? 1.59%.[iii] And now, of course, they are all the way down to 0.9%.[iv] In the interim the US has had no debt crisis and 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 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 fear seems largely absent, and in our view, for good reason. It has always been clear to us that the NRSROs—S&P, Moody’s and Fitch—based their decisions on backward-looking information. That would be the same information that markets previously digested. In 2011, S&P’s stated downgrade rationale was the protracted debt ceiling battle, which had ended three days prior.[v] Investors had spent months dealing with panicky headlines and shouting politicians. Markets, which deal efficiently with widely known information, reflected all of it—including the many rumors 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 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 June 24, when Canada’s 10-year yield was 0.55%.[vi] It is now 0.74%, mirroring rate rises in the US and other nations that weren’t downgraded this year.[vii] More recently, Moody’s downgraded the UK on October 16. That day, 10-year gilt yields closed at 0.17%.[viii] Since then, they have risen all the way to 0.26%—a move also paralleling most major developed markets.[ix]
Rating sovereign issuers isn’t the NRSROs only job. They also rate corporate debt, and here, 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 favorable rating, lest the issuer not like a tough rating and decide to take their business elsewhere. Many blamed issuer pays for inaccurate credit ratings during the financial crisis, and 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.”[x]
A grand irony to note here is that just as pundits 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 regulation (including Dodd-Frank, by the way) 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 improves the world’s general understanding of how markets work—always and everywhere a good thing. (Provided this understanding sticks over time.) It also inspires investors to look increasingly beyond raters’ grades and do their own due diligence, which increases awareness and aids price discovery. Perhaps most importantly, 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 12/15/2020. 10-year US Treasury yield (constant maturity) on 8/5/2011.
[ii] Ibid. 10-year US Treasury yield (constant maturity) on 9/6/2011.
[iii] Ibid. 10-year US Treasury yield (constant maturity) on 8/6/2012.
[iv] Ibid.10-year US Treasury yield (constant maturity) on 12/14/2020.
[v] We will let you decide whether this rationale really was behind the downgrade or the firm’s math, which included a multi-trillion dollar error.
[vi] Source: FactSet, as of 12/15/2020. 10-year Canada benchmark government bond yield on 6/24/2020.
[vii] Ibid. 10-year Canada benchmark government bond yield on 12/15/2020.
[viii] Ibid. 10-year UK benchmark government bond yield on 10/16/2020.
[ix] Ibid. 10-year UK benchmark government bond yield on 6/24/2020.
[x] “Beginning of the End for the Ratings Agencies’ Dubious Influence,” Ross Gittins, The Sydney Morning Herald, 12/14/2020.