Are Credit Ratings Different from Bond Valuations?

Widespread confusion appears to exist among the investing public as to the potential distinction between ratings and valuations. Are they the same? If not, how exactly are they different, and is one more “useful” than the other as a financial measure? Even the SEC is now confused, something quite surprising in light of the fact that they are supposedly regulating rating agencies. Given the importance of this practical distinction, it’s worth spending a few minutes dispelling rumors, lies and innuendos.

At a fundamental level, both ideas are identical and the issue of their supposed kinship or difference makes no sense at all. It is equivalent to asking about the difference between degrees Fahrenheit and degrees Centigrade: both are temperature-measurement systems. The only difference is that one system is used in America while the other one is used in Europe and elsewhere. (Should we call this “l’exception Américaine?”) If someone now living in Paris suddenly woke up in New York, confusion would reign only until he learned the new system, which would take less than a day, or even faster if he headed to the beach when the thermometer read “30 degrees.” The point is that a self-consistent system is always usable but only makes sense within its own context. No harm will be done by using either system as long as it is used appropriately. Since a simple transformation function exists between them, any confusion on the part of a user can be cleared up immediately with a mapping function.

Likewise, it is silly for any one person or governmental body to insist on the use of a particular system as long as what is used is self-consistent: an increase in the measure corresponds to an increase in the phenomenon being measured. What should be insisted upon, rather, is that systems be self-consistent, instead of assuming they are a priori. Confusion over meaning can be made to vanish by delivering, to anybody who cares to ask, the mapping function transforming the measures in the proposed system into measures in the “official” or standardized one, in the manner previously demonstrated.

In a nutshell, the battleground of rating quality ought not to lie in a regulator’s insistence on the use of a particular, consistent measurement system, but rather that new measures be more useful than old ones. This is how advances in financial understanding can be realized at little to no cost.

The fact of the matter is that traders and other investment professionals are ill-served by the current letter-grade system, especially in structured finance. Although finance is about numbers, not letters, we all understand how and why the AAA, AA, etc. system was instituted by John Moody ca. 1909. To gain acceptance, the system had to speak clearly to people living in the early 20th century. Back then, and unfortunately still to a large extent today, fixed income finance was unsophisticated. Most bonds were bought as long-term, “buy-and-hold” investments, and the only practical distinction between them was whether they were “good,” i.e. literally investment grade, or “bad,” i.e. non-investment grade. Although nobody had ever said the rating nomenclature had to stay that way, least of all John Moody, apathy and inherent conservatism among financial professionals and their investments conspired to leave the system unscathed for almost seventy-five years. After that, Moody’s introduced a “notching” concept to expand the non-investment grade scale during the ascendency of so-called “junk” bonds (whose label was unfortunately too self-explanatory).

Letter grades are useful today only to the extent they provide a trivial way for regulators and politicians to partition the world into the “good” guys and the “bad” guys. The world of finance has become too complex for traders and fund managers to afford to rely on such simplistic measures. Instead, what these folks and the rest of the financial marketplace sorely needs is bona fide valuation, i.e. strictly a numerical measure, since this is how one must understand value in financial instruments. The numerical measure is usually called a “credit spread,” easily convertible by any financial professional worth his salt into a current fair market value on the bond. Since letter-grade ratings and credit spreads are directly convertible into one another, making an issue out of which one ought to count as a bona fide “rating” is just making a distinction without a difference and really wasting everybody’s time.

Instead of letter grades, we believe credit spreads should be delivered as such to financial analysts, since this is what they will use anyway to compare alternative investments. Savvy rating agencies ought to deliver both measures, letters of the alphabet and credit spreads or fair market values, as part of their standard setting and client-offering. This information would actually help their clients do deals instead of confusing their clients hopelessly about the only thing they need to know and which is precisely what the agency does not give them.

In particular, trading shops would be amazed to be given a metric from a reliable third-party that enables them to price bonds directly, instead of having to distill the letter-grade alchemy in real time and hoping the agency is not sleeping at the switch. Just so we’re clear, all NRSRO’s now in existence have been known to do just that in recent times, and are continuing to do so by the way. The excuse that rating agencies don’t want to do this because that would be interfering with the normal process of deal-making is nonsense. It is exactly what they are supposed to do. Is a State trooper “interfering” with highway traffic?

Unfortunately, no rating agency has ever published its mapping function from letter-grades into equivalent valuations or credit spreads. The possible exception is Moody’s Investors Service, which at one point in time circulated the reduction of yield scale that it used until 2000.  Mind you, the reduction of yield from the nominal coupon promise is itself not a valuation, since it needs to be modulated by the current yield curve in order to become a true credit spread. It is not difficult, but as far as we know R&R Consulting is the only firm to have done this. We set out the method in excruciating detail in Chapter 22 of “Elements of Structured Finance”, published by Oxford University Press in 2010.

Producing an actual credit spread or fair market value is the only workable way to establish a meaningful dialogue with the people that use these data in their daily work. Only then will the valuation loop close, to allow markets to remain in dynamic equilibrium, at all times, according to standard arbitrage-free arguments. Nothing else but a credit rating that is a valuation will work.