This article first appeared in Personal Finance Magazine, 3rd quarter 2017.
The major credit rating agencies have come in for criticism on a number of fronts. It is claimed that they operate something akin to a “closed shop”, and the market would benefit from more competition.
Questions have also been raised about the conflict of interest that apparently arises because the issuers of bonds choose and pay agencies to rate their bonds. It is also claimed that the major agencies have a bias against emerging countries, and therefore the BRICS (Brazil, Russia, India, China, South Africa) should establish their own ratings agency. What are South African asset managers’ views on these criticisms?
Tyron Green, a credit analyst at PSG Asset Management, says there are only two dominant rating agencies in South Africa.They have been able to gain more pricing power, but Global Credit Ratings has been able to grow its coverage. Although there is a conflict of interest in that companies choose – and pay – the rating agencies, the ratings go through the agencies’ committees before they are issued. This same conflict exists with companies choosing and paying their auditors.
“This will, in part, be mitigated by our assessment of the integrity of management and to a greater degree through our own rating assessment,” Green says.
“We have found in many instances that, as the rating agencies are relatively removed from the local market, they are more reactive than proactive in their rating changes. Therefore, a BRICS rating agency will most likely still not solve the problem.
“The BRICS still operate in different industries with different legal frameworks and regulations. The rating agencies use a yardstick with which they measure each company and compare them to their peers globally, but the measure is not always relevant or correctly weighted to each country or company. A potential solution to this problem could be some form of local presence and adaption of the yardstick and weightings, rather than just introducing a BRICS rating agency,” Green says.
Ockert Doyer, a credit analyst at Sanlam Investments, says conflicts of interests remain a concern. This is somewhat balanced by the agencies’ need to retain investors’ confidence in their ability to form objective and balanced views.
“Competition in most industries normally leads to better products and services for consumers, but in the credit ratings business a few (three, maximum four) large but trustworthy players are probably sufficient. Investors want broad coverage by the agencies they subscribe to, and having too many different methodologies for assessing credit risk will not necessarily add any value.
“Shopping around until you get an opinion that you want to hear, rather than an opinion that you need to hear, is a very dangerous approach,” Doyer says.
Nazmeera Moola, the co-head of fixed income at Investec Asset Management, says she is not convinced that more rating agencies will improve the situation.
She says the ratings provided by the three agencies based in the United States – Fitch, Standard & Poor’s and Moody’s – do not differ markedly from those provided by the Japanese agency Rating and Investment Information. And although the rating from Chinese rating agency Dagong is somewhat higher, “the direction of travel” is exactly the same. At the same time, most of the investors in South African government debt are from the US, the United Kingdom and Europe.
“We may not like what the rating agencies say, but we cannot ignore them until we stop needing to borrow money every week from foreign and local investors who care about credit ratings. Unless the pension funds of Brazil, Russia, India and China start buying South African government debt, a BRICS rating agency will not change this.”
John Orford, a portfolio manager at Old Mutual Investment Group’s MacroSolutions boutique, says that in principle more competition is good for any market. Ratings agencies do face a potential conflict of interest, and this has led to concerns about their role, particularly in the 2008/9 financial crisis in the US.
“However, from our perspective, our investment decisions are not taken on the basis of a ratings agency view, but on the basis of our own investment process and the respective merits of any asset class or security. This may take into account ratings agencies’ views, but only as one piece of data within a much bigger picture.
“A BRICS rating agency could provide a useful service if it was a competitive, independent ratings agency. It would certainly face considerable scrutiny if it was funded and controlled by BRICS governments,” Orford says.
Henk Viljoen, the co-head of Stanlib’s fixed-interest business, says the credit rating agencies are regulated by the Financial Services Board in South Africa and are required to comply with the Credit Rating Services Act (CRSA). The scope of the CRSA is referenced to the International Organisation of Securities Commissions’ code of conduct, which covers independence, circumventing conflicts of interest, and responsibilities to the investing public and issuers.
“It is questionable whether a BRICS rating agency or any new credit rating agency will be useful, as credibility and reputation will have to be earned and demonstrated before recognition is assigned to its opinions.”
Samantha Steyn, a portfolio manager at Cannon Asset Managers, says there is no doubt that a rating agency’s relationship with a debt issuer gives rise to a major conflict of interest. Agencies do, however, offer valuable information to investors so they can compare countries and debt issuances.
“It is definitely not the best single measure from which to judge. The agencies have been criticised for being behind the curve or after the fact, and often follow each other’s rating moves. However, I am not convinced that more competition in this area would provide a solution.
“It might be useful to have an emerging-market or BRICS rating agency, as these economies are far more comparable, and this would allow more focused attention on some of the smaller economies, which are often larger debt issuers due to their growth requirements.”
Izak Odendaal, an investment strategist at Old Mutual Multi-Managers, says the reputation of the major ratings agencies took a knock after the global financial crisis, partly because they were paid to rate sub-prime mortgage instruments. However, when it comes to sovereign ratings, there is neither an apparent conflict of interest nor any reason to suspect a hidden agenda.
“It is not clear whether having more major ratings agencies in the South African market would have a positive influence on the view of South Africa’s creditworthiness. Not that they have exactly the same view in any case; Moody’s has long been more generous in its assessment of South Africa than the other two.
“A BRICS ratings agency would be useful to investors only if it offered credible and objective research and opinions. It is difficult to envisage such a ratings agency gaining the confidence of international investors any time soon. If such a ratings agency is established, the BRICS bank can use those ratings for its lending activity (similar to the role played by any bank’s credit department),” Odendaal says.
Rowan Williams-Short, the head of fixed interest at Vunani Fund Managers, says ratings – produced by mortal, fallible analysts – have too much influence over markets, policymakers and investment mandates. Further, ratings are at best ordinal; not mathematically precise. A TV weather announcer may decide that 12⁰C is mild, but 11⁰C is cold. The distinction between investment grade and non-investment grade is just as subjective.
“Out of the plethora of analysts’ views on rated entities, why do we give such heavily skewed credence to rating agencies?
“More competition among rating agencies should be welcomed.
“Rating agencies are ostensibly conflicted by their remuneration models, but no more so than auditors, whose billing arrangements are widely accepted. Good ethics and a commitment to pure objectivity should be able to overcome potential conflicts.
“A BRICS rating agency would be utterly futile and would be deemed by developed markets to have as much credibility as one side’s cricket captain simultaneously serving as the match umpire.
“The very notion of, and motivation for, a BRICS rating agency smacks of a scolded child’s sulks. South Africa’s BRICS partners are, in any event, not feasible contributors to the financing of our borrowing requirements; our own institutions and developed markets are the only plausible candidates,” Williams-Short says.
Evan Jankelowitz, a director and portfolio manager at Sesfikile Capital, says holes can always be poked in the ratings agencies’ processes and errors of judgment.
“However, with regards to our current circumstances in South Africa, we don’t see any undue force being exercised; rather prudent warnings to existing and potential investors who rely on a standardised metric in analysing sovereign risks across the globe.”
Daryll Owen, a balanced-fund portfolio manager at Foord, says, in theory, the power of the ratings agencies to influence decisions waned somewhat after the global financial crisis highlighted their failings, and legislation was passed in the US to help resolve the potential conflicts of interest.
“Most global top-tier investment firms claim to use ratings agency reports only to supplement their in-house research. However, in reality, investment mandates and some regulations still often set minimum ratings levels, below which forced trading is required. So the ratings agencies do still influence investment outcomes and therefore a country’s borrowing costs. This is unlikely to change, and maintaining an acceptable credit rating will remain a key priority for borrowers.
“Notwithstanding regulatory intervention, conflicts of interest remain endemic across the financial services industry. Market participants that are alive to this reality are more likely to identify mispricing and will be better placed to exploit the resultant opportunities.
“It is not clear to us what a BRICS rating agency would do differently, and so it is doubtful that a BRICS rating agency would gain much traction outside of the BRICS themselves. In our view, the industry needs fewer agents, not more,” Owen says.
Janine Plein, a credit analyst at Argon Asset Management, says rating agencies provide an opinion, which investors can ignore if they don’t agree with it. It takes a substantial amount of time to set up an agency that provides credible ratings.
“Rating agencies apply historical default trends and probabilities of default when determining a rating. This knowledge base takes time to build, and new rating agencies must prove their worth before their ratings are seen as credible.
“Rating agencies have Chinese walls between their analysts and the front-office business-generating units. Therefore, we believe the ratings are independently derived.”
Craig Sherman, a credit fund manager at Ashburton Investments, says there are specific situations in which rating agencies may have too much influence. These are limited to when the rating of an issuer faces an inflection point, such as a move from investment grade to sub-investment grade. However, in the normal course of business, the actions of a rating agency usually have limited consequences.
“This issue will not be solved by increased competition, as this will most likely introduce further complexities for investors when considering rating-driven guidelines. The absence of Fitch from the South African market has not had any profound influence on investors, as most issuers have managed to transition to a new rating agency without much consequence.
“In our experience, when embarking on a process to assign a rating to an issuer, we felt that all conflicts of interest were adequately addressed by internal controls having been strengthened after the global financial crisis. Absent demonstrable proof that the incumbent rating agencies are unfairly prejudicing South African issuers, we don’t see the introduction of a BRICS rating agency as having value,” Sherman says.
Craig Sorour, the head of South African research at Laurium Capital, says rating agencies are measured in their approach and are very cognisant of the implications of downgrading a country.
“In our view, they have given South Africa the benefit of the doubt in the past, but recent political noise appears to have reduced their ability to continue to do so.
“While conflicts of interest are inherent in their business, we believe that the global financial crisis refocused the rating agencies on the need to maintain their independence. In our view, they are still in the process of rebuilding trust with the market in fulfilling a very necessary function.
“Notwithstanding the well-documented shortcomings and criticisms of these agencies, global investors place significant ‘stock’ in their recommendations. This is based on methods and process gathered over a long time.
“If a BRICS agency were to emerge, it would need to prove to investors that it applies the same standards and principles as the incumbents, and gaining investors’ trust is likely to take a long time,” Sorour says.
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