Reality stars are famous for being famous. We should not begrudge them for recognizing an opportunity, seizing the momentum and exploiting it successfully. However, an approach that emphasizes form over substance can neither be consistent or highly repeatable.
Recently, in the case United States of America v. McGraw-Hill Companies, Inc and Standard & Poor’s Financial Services LLC, the defendant requested dismissal of the case on the grounds of “puffery.” At the heart of the case, the U.S. Department of Justice (DOJ) is alleging that Standard & Poor’s (S&P) engaged in a scheme to defraud investors by asserting that its credit ratings were independent, objective and uninfluenced by conflicts of interest, when if fact the rating agency knew that the credit ratings were based on a desire to win business. The DOJ is focusing its case on certain residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) that included the securities. In its request to the dismiss the case, S&P claimed, “statements concerning the “integrity and credibility and objectivity of S&P’s credit ratings” were exactly “the type of mere ‘puffery’ that have previously held to be not actionable.” That such statements were “so general that a reasonable investor would not depend on [those statements.]” It is worth repeating that S&P’s defense that none of the public statements made regarding procedures for providing objective, independent assessments of credit quality should be relied upon by a reasonable person. So in essence, S&P’s credit ratings have no substance, only form.
Much like we should not begrudge them for seizing the moment, perhaps we should give S&P the same benefit. The DOJ is seeking to recover more than $5 billion in losses from the rating agency. Maybe the puffery defense is just legal wrangling to avoid a hefty penalty. S&P in its request for dismissal also cries foul in that the DOJ is singling it out while Moody’s and Fitch also rated the securities in question.
In its defense, S&P raises an interesting question. Should investors rely on rating agency credit ratings when making an investment decision? Are agencies’ ratings really form over substance that no reasonable investor should rely upon? Have the agencies become famous for being famous? By comparing rating trends and quality distributions to various credit ratios in the investment-grade corporate bond market since 2000 (a period that witnessed the Enron induced power crisis, the WorldCom kickoff of the telecom/tech crisis and Lehman’s start of the financial crisis), interesting conclusions can be drawn on the reliability of agency credit ratings.
The first 12.5 years of this century have witnessed some unprecedented turmoil in the credit markets as three large, corporate issuers rated solidly investment grade by the rating agencies defaulted in rapid fashion. None was more spectacular than Lehman that was single A on Friday and defaulted on the following Monday. In addition, as highlighted in the DOJ case against S&P, the multiple investment- grade structured issuers that experienced principal loss cannot be overlooked.
Below is a distribution of the rating agency corporate credit ratings of the Barclay’s Corporate Index at the beginning of the century, the end 2012 and the end of the last quarter. As can be seen by the red and green bars, the quality of the investment-grade bond market as determined by agency ratings has deteriorated. By year-end, the expectation is the chart will become more skewed toward BBB as the agencies complete their methodology review of the banking industry.
Using the same end periods, the following charts highlight the key metrics for approximately 180 industrial issuers in the Barclay’s U.S. Corporate Index. The first chart looks at leverage as measured by Debt to Earnings Before Interest and Taxes (EBITDA) and Debt to Free Cash Flow (FCF). Both demonstrate notable improvement in the aggregate industrial universe of issuers. This is in contrast to the agency credit ratings.
Investment-grade industrial companies could pay off their debt in approximately two years (Debt/FCF 2.1x), assuming stable FCF. However, we do not believe investment-grade companies will do so. Our expectation is that a Debt/FCF level will be maintained at around 2.0x in 2014.
The next chart highlights profitably measures. While the last 12.5 years has been tumultuous, on average investment-grade companies have maintained profitability margins of around 20%. Additionally, capital investment has remained fairly constant at approximately 7.5% of sales. And more importantly, investment-grade companies have become more efficient generators of FCF, turning approximately 75% of earning into FCF, up from 73% during 2000.
As these simple charts highlight, the credit quality of the investment-grade bond market has not deteriorated. It has improved moderately since the beginning of 2000. Nor do we expect quality to deteriorate over the near term. So if the expectation is for stability, why do agency ratings suggest a deterioration? Much of it can be explained by being reactionary, as seen in the notable drop in credit ratings following every credit crisis, similar to the notching down we expect to see in the banking industry by year-end. But perhaps it is just that S&P’s assertions are correct. The rating agencies’ independence and objectivity are mere puffery.
At Columbia Management, our analysts pride themselves on intensive, independent, forward-looking, proprietary credit research. We strive to know our credits as well as, or better than anyone else. We do not think we will ever have a Kardashian moment and claim our process and philosophy is mere puffery. We value substance over form.
The views expressed are as of 8/12/13, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.
There are risks associated with fixed income investments, including credit risk, interest rate risk and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.
© 2013 Columbia Management Investment Advisers, LLC. All rights reserved. 711497