Communicating in the Language of Bonds

 This past Friday afternoon, Standard & Poor’s announced that it was downgrading the sovereign credit rating of the United States to “AA+” from “AAA.” On Monday morning, the first time the U.S. markets opened after the announcement, stocks dropped precipitously, because, said the pundits, the markets had been taken by surprise by the downgrade. Should the market have been surprised? In order to make that determination, one needs to understand some of the workings of the bond market.

Ms. Picky’s mission is to discuss language and communication, and there are many niches of business and activities that have their own special language. The week’s events put the spotlight not just on finance, but on the particular terms and situations related to the bond markets and the rating agencies. Since many people who are worried about their nest eggs are being told that the downgrade of the U.S. sovereign rating is responsible for the market meltdown, they are seeking clarification on the language and workings of the bond markets and the rating agencies. 

Ms. Picky hopes that this post will go at least some of the way toward communicating in plain language the meanings of some of the terms being used in the news this week and allow a proper assessment of the situation.

Above/Below Par. We know that, at par (a bond’s price at its initial offering), the amount of a bond’s coupon (the interest it pays) is set, and, although the coupon amount doesn’t change over time, the bond’s price (either a discount or a premium to par) fluctuates in the marketplace, relative to interest rates in general, and relative to the prices of other, similar bonds. 


Basis Point. A unit equal to 1/100th of 1 percent. It is used to calculate changes in bond rates and yields.

Bond Ratings. The “quality metrics” used to compare similar bonds. Ratings are assigned by the rating agencies, which allow buyers to make apples-to-apples comparisons in judging bonds’ value relative to one another.

Correlation. The relationship of two different asset classes to each other and the likelihood of their moving in the same direction, e.g., the historical correlation between the price of gold and inflation, or, at one time, the inverse correlation of stocks and bonds. 

Fiduciary Responsibility. A financial advisor who has a fiduciary responsibility to his or her clients is vulnerable to being sued if he gives financial advice that turns out to be bad. Some people hold that the rating agencies play the role of fiduciaries, and say that, because the agencies got mortgage-backed securities ratings wrong in 2007-08, they should have been held liable then—and should be held similarly liable now—for the accuracy of their opinions. The rating agencies, however, say they don’t claim to be fiduciaries, and maintain that, because their published press releases are only opinions, they are entitled to the protection of the first amendment and the right to freedom of speech. Indeed, they ask, how can they offer their opinions at all, if they have to operate under threat of lawsuit from anyone who has a different opinion?

Modern Portfolio Theory (MPT). A mathematical formulation of the concept of diversification in investing, in the belief that a collection of different asset classes has lower risk than any individual asset, because of diversified assets’ different correlations with one another. With the faster transmission of information and the interconnectedness of business and nations that exist today, however, MPT has mostly fallen out of favor, because historical correlations have changed, and now even asset classes unlike one another often behave in similar ways. On Monday, for example, it was a bond rating that was downgraded, but it was the stock market that fell.  

Rating Agencies. The “Big Three” rating agencies are S&P and Moody’s (which are American) and Fitch (which is French). There are more than a hundred various other, smaller, specialty, and regional agencies in the world, with varying degrees of credibility, depending on their perceived objectivity or agendas, but, in the last hundred or so years, it is the influence of the three major rating agencies that has gradually grown the most, as the financial industry became dependent on their ratings as risk metrics and pricing tools.

Risk Off. The defensive posture taken by investors in a period of global and domestic economic woes: the selling of risky assets for perceivedly less-risky assets. (At one point in history, bonds were seen as generally less risky than stocks, but that is no longer true, and the once-sleepy bond market has proved to be as volatile, in its own way, as the stock market.) When the markets fall rapidly, traders sell even securities that have been perceived as “low risk” in order to move to “no risk,” i.e., cash.

Role of the Rating Agencies. With any item for sale, whether bonds or bananas, one cannot consider a price cheap or expensive without having an idea of the item’s quality. The role of the rating agency is to use established metrics to assign ratings that are commonly understood.

The Relevancy of the Rating Agencies 

After the 2008 financial crisis, some people began to question the relevance of the rating agencies. Are the agencies relevant to our financial system? Let’s take a look.

In July 2010, when President Obama was about to sign the landmark Dodd-Frank financial reform bill into law, a last-minute provision was included that would make the rating agencies legally liable for the accuracy of their ratings. 

Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings reacted by going on strike: They refused to allow their ratings to be used in documentation for some new bond sales, because, they said, they feared being exposed to legal liability regarding the accuracy of their ratings opinions. 

  

The rating agencies’ refusal to rate the bonds created immediate havoc in the bond markets, parts of which shut down entirely. Why?* Because some bonds—for example, those made up of mortgages, autos, student loans, and credit cards (many of which had been bought by mutual funds and pension funds to fund employee-retirement programs)—were required by law to include ratings opinions in their official documentation. If the rating agencies refused to give their opinions and rate the securities, new bond sales in the $1.4 trillion market for asset-backed securities would have to shut down.

  

The stalemate was broken when the House Financial Services Committee finally passed the Asset-Backed Market Stabilization Act of 2011, protecting rating agencies from liability,** and the rating agencies resumed giving their opinions. 

But it is not only the asset-backed securities market to which rating agencies are relevant. Many mutual and pension funds have internal-regulations language stating that the fund will not hold bonds rated lower than a certain level. Such funds’ managers have a fiduciary responsibility, then, if bonds the fund is holding are downgraded below that level, to sell them. 

The way ratings are integrated into the markets also means that, if a downgrade puts a lot of selling pressure on the security, its price drops, to compensate the buyer for purchasing a riskier security.

If the company then issues additional bonds, it will have to offer purchasers a higher coupon. Just as individuals with poor credit have to pay a higher interest rate than those with good credit, so too do companies with lower-rated credit have to pay more to their bond investors, to get them to buy their bonds, and the expense of higher debt service can weigh on a company’s profitability and eventually affect its stock price.

The Current Situation:

The “Surprise” of the S&P Downgrade

of U.S. Sovereign Credit

Now that we’ve got some background, let’s come down to the particular: the S&P downgrade of the U.S.’s “AAA” credit rating. Here’s the sequence of events:

1. S&P announces that, if the U.S. Congress cannot manage to slash the deficit by $4 trillion, there is a possibility of a U.S. downgrade.
2. Weeks later, Congress, after a reckless game of brinkmanship that threatens global financial markets, slashes the deficit by only $2.4 trillion.

3. S&P cuts the U.S. credit rating one notch, to “AA+.”

4. Like Captain Renault in Casablanca, who is “shocked” that there is gambling going on in Rick’s Place, the markets are “shocked” at the downgrade.  


No matter what your “take” on the rating agencies, there is no reason that anyone involved either in the bond markets or the government should have been surprised by S&P’s call. 

Ironically enough, when the market fell, supposedly in reaction to the downgrade, one of the “flight-to-quality” trades (in addition to gold and the Swiss franc) was the very U.S. treasurys whose downgrade was supposed to have caused the market to fall, a fact that is causing some to say once again that the rating agencies are irrelevant.

As can be seen from the examples above, the rating agencies are very relevant to the way our financial systems operate. In addition, we would be putting our heads in the sand if we did not acknowledge at least to ourselves that the U.S. is in poorer fiscal shape today than it was twenty years ago. Aren’t we shooting S&P for being the messenger—and telling us something we already knew anyway?

The good news is that an “AA” rating is still very respectable, as evidenced by the treasury-buying on Monday. 

The bad news is that we need to do some belt-tightening and get our fiscal house in order—but so does most of the rest of the world, most nations even more so than the U.S.


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*“Bond Sales? Don’t Quote Us, Request Credit Firms,” Anusha Shrivastava, wsj.com, July 21, 2011.

**“Don’t Let the Rating Agencies Regain Their Old Powers,” AmericanBanker.com, Michael Shemi, August 4, 2011.

This blog has been read in Algeria (Unrated), Argentina (“B”), Australia  (“AAA”), Bangladesh (“BB-”), Brazil (“BBB-”), Canada (“AAA”), China (“AA-”), 

Croatia (“BBB-”), the Czech Republic (“A”), Denmark (“AAA”), Ecuador (“B-”), Egypt (“BB”), El Salvador (“BB-”), France (“AAA”), Germany (“AAA”), Greece (“CC”), Honduras (“B”), Hong Kong (“AAA”), India (“BBB-”), Indonesia (“BB+”), Ireland (“BBB+”), Israel (“A”), Italy (“A+”), Japan (“AA-”), Kazakhstan (“BBB”), Kenya (“B+”), Latvia (“BB+”), Malaysia (“A-”), Mali (Unrated), Malta (“A”), Mexico (“BBB”), the Netherlands (“AAA”), New Zealand (“AA+”), Nigeria (“B+”), 

Pakistan (“B-”), Peru (“BBB-”), the Philippines (“BB”), Poland (“A”), Russia (“BBB”), Singapore (“AAA”), Slovenia (“AA”), South Africa (“BBB+”), South Korea (“A+”), Spain (“AA”), Sweden (AAA”), Taiwan (“AA-”), Thailand (“BBB+”), the U.A.E., the U.K. (“AAA”), Ukraine (“B+”), Uruguay (“BB+”), the U.S. (“AA+”), and Vietnam (“BB-”).***

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***Ratings given are Standard & Poor’s foreign ratings as of August 9, 2011.