NEW YORK (Reuters) - The $6 trillion corporate bond market is signaling that rating companies are missing the mark, again.
Over the last month, U.S. investment-grade debt began trading like junk bonds, and most U.S. junk bonds are trading at distressed levels, suggesting an alarming rise in default and bankruptcy risk.
The market’s view of corporate credit quality has never differed so dramatically from ratings.
Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are already under fire after the collapse of the subprime mortgage market triggered a global financial crisis. At a congressional hearing on Wednesday, lawmakers blasted the agencies for giving high ratings to complex mortgage-linked securities that later collapsed in value and sent shock waves through the financial markets.
Some strategists say a similar phenomenon may be playing out in some corporate bonds, whose ratings may not reflect a completely changed and riskier credit landscape. Moreover, the problem will be especially acute for issuers that sold bonds assuming they would have ready access to capital markets.
“The issues with corporate ratings are probably less striking now than the debacle with structured finance,” said Ed Grebeck, chief executive officer of Tempus Advisors in Stamford, Connecticut. But he said rating firms are not ahead of the curve for some basic corporate bond ratings, “and it’s supposed to be their core competency.”
Press officers at all three companies say ratings are based on a committee review process that results in their best opinions on the credit profile of a company or its debt.
The rating companies also say they only issue opinions, which should not be used to make investment decisions. But corporate bonds are priced and sold based largely on the ratings they receive, and recent criticism has resulted in a review by all three firms of their structured bond rating procedures.
Morgan Stanley analyst Rizwan Hussain says rating companies must take a longer view and avoid a “yo-yo effect” when ratings change too quickly to reflect short-term market moves.
To be sure, rating agencies are catching up with the market’s pessimistic view.
Downgrades by Moody’s totaled a record $2.2 trillion in the first three quarters of this year, up from $311 billion a year earlier. Standard & Poor’s cut ratings for 155 issuers in the U.S. in the third quarter alone, versus an average of 99 cuts per quarter since 2002.
“We have been lowering overall corporate bonds, and there will be additional downgrades,” said S&P analyst Diane Vazza.
Yet bond prices are reflecting even more stress than reflected in current ratings.
Investment-grade bonds now yield nearly 6 percentage points more than Treasuries, well above the average historical yield spread on junk bonds of 4.5 percentage points. Large chunks of the junk bond market are trading at distressed levels, with average yields at a record 16.3 percentage points over Treasuries, according to Merrill Lynch data.
The record high yield spreads partly reflect forced selling by troubled funds, which has pushed some bonds below their fundamental value, strategists say. Bonds are also pricing in an unprecedented freeze in lending markets that neither rating agencies nor other analysts foresaw.
Companies are feeling pressure from the worst borrowing environment in at least a generation, and some investors worry that ratings have not yet caught up to that new reality.
Jerome Fons, a former Moody’s executive, said in written testimony to the House Oversight Committee this week that many weak financial institutions have ratings fixed at inordinately high levels because analysts fear the panic that a downgrade can cause in today’s markets.
A prime example: Lehman Brothers was rated investment-grade before its bankruptcy filing on September 15.
Fons also said conflicts of interest were created by the rating agencies’ business model, in which issuers paid for ratings.
Sean Egan, managing director of independent rating agency Egan-Jones Ratings, said the credit crisis will not pass until more is done to restore confidence in ratings.
“The system is broken,” he said, noting the $3 trillion allocated by governments for rescues has not addressed the core problem in the credit markets, which is lack of trust in ratings.
Peter Andersen, portfolio manager for Congress Asset Management in Boston, said rating agencies and investors alike will likely now use what he calls “shock” analysis.
“Let’s assume bank lines are gone and the financing capabilities are zero — how does the company look then? I think you will see more of that from rating agencies because that is what is implicitly being done by the price of the bonds right now.”
Reporting by Dena Aubin and Walden Siew; Editing by Dan Grebler