Unrated Debt an Emerging Global Trend

Once thought inconceivable, an interesting trend was uncovered in the October 29th The Wall Street Journal, there are a number of debt issuing firms foregoing the traditional credit rating process. In an article titled Credit Rating Now Optional, Firms Find, the Journal points out some globally prominent firms and governments have decided not to have their bonds and debt backed securities to be offered rated by any of the major credit rating agencies. Instead, these issuers are insisting that their investors do their own analysis of the cash flows and risks involved in each security.

This is a noteworthy trend as ratings from the major rating firms like Moody’s (MCO) and Standard & Poor’s (MHP) in some cases were seen as a rubber stamp authenticating debt and its associated risks. However, these agencies have come under scrutiny during the credit crisis as many of their ratings have been proven unreliable. Some would argue that the credit crisis exposed risks in highly rated debt issues that seemed to catch the agencies asleep at the wheel. The emergence of non-rated debt does suggest a lack of confidence or at least lack of necessity of these established guidelines. As the CEO of Italy’s Gruppo Campari was quoted as saying, “Our reputation is good….I don’t think a rating would have mattered that much.”

The lost credibility is clearly not the only contributing factor to the rise of unrated debt securities. Possibly more influential in these unrated issues is the speed at which the financing can be gained without a credit rating. Credit rating firms can take months to issue a rating on debt, and not to mention this is not a cheap undertaking. If a company needs capital more quickly, they can simply raise the rate slightly to attract more interest from institutional lenders who will be conducting their own due diligence with or without a rating anyway. For the issuer, it is obviously a tradeoff between cost of capital and speed of the deal.

For now, it appears there are enough lenders ready and willing to undertake their own review in order to attain a higher return. With many institutional managers and hedge funds still smarting from the credit crisis, an extra return can easily compensate for doing more of their own research. In some cases the extra interest earned over the course of the loan can be substantial, as the article points to this specific instance from Dubai.

“The Persian Gulf emirate’s economy has been hard hit by downturns in real estate and the financial markets, but its unrated bonds attracted risk-taking investors looking for yield. The Dubai government sold the debt for a yield over 6%, compared with 3.85% yields on comparable debt of neighbor Abu Dhabi, which has a strong credit rating of double-A and recently provided Dubai with financial support.” — Credit Ratings Now Optional, Firms Find

The point of this post is not to pass judgment on the major ratings firms, as we all know plenty has been written and said about their short comings. Rather, the point is to highlight an intriguing trend in debt instruments; a trend that has been used by firms such as Highland Capital Management, Heineken NV, Gruppo Campari and Credit Suisse (CS). The credit rating firms provide a service that many investors cannot do without, and the evolution of unrated bonds should motivate them to improve and not repeat mistakes that have harmed their credibility. However, the emergence of independent research and due diligence is what is more interesting to us at Ockham.

At Ockham, we try to make a point of telling clients that no investors should rely on one source of information for an investment decision. We think of our research as a baseline for understanding and an aggregator of information, but it cannot supplant additional due diligence. Investments should be rooted in a true understanding of where you are putting your money, and risks should always be weighed. The ultimate responsibility for an investment lay with the investor who has taken on the risk.

Unrated Debt an Emerging Global Trend

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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