In the mid-1980s, U.S. life insurance company Executive Life invested the majority of its assets in bonds with a rating of “BB+” or lower. In spite of this low-quality portfolio, the rating agencies gave the company an “AAA” rating. So how was it possible to become an “AAA”-rated entity with below-investment-grade assets? The subsequent bankruptcy of the company proved it was not and came at considerable cost to policyholders.
At another life insurance company, the investment team decided to meet its average “A”-rating pricing standard with a combination of “BB” below-investment-grade bond investments and actively traded “AAA” U.S. Treasury securities. The assumption was that the investments would average each other out to achieve the “A” pricing standard. On a cash flow basis, this approach appeared to work. Unfortunately, as below-investmentgrade bonds began to default on their obligations, their credit spreads(the difference between the corporate bond’s yield and the benchmark government bond’s yield)widened and the market value surplus soon became a substantial deficit.
This lesson is reminiscent of the current subprime mortgage debacle in the U.S. Sub-prime lending generally refers to loans extended to borrowers who do not qualify for market interest rates because of problems with their credit history. These mortgages are obviously higher-risk and more likely to default. In an effort to minimize the default risk, riskier sub-prime mortgages are combined with other higher-rated mortgages in asset-backed securities called Collateralized Debt Obligations(CDOs). Credit risk in CDOs is divided among different tranches: senior tranches (rated “AAA”), mezzanine tranches(rated “AA” to “BB”)and equity tranches(unrated). Once collateralized into a CDO, sub-prime mortgages that initially started out as substandard investments on a stand-alone basis became, in some tranches, “AAA”-rated investments. During the recent U.S. meltdown in the residential housing market, a number of the “AAA” tranches have been downgraded or placed on credit watch by the various credit-rating agencies as the collateral backing the “AAA” rating has deteriorated.
The lessons from the first example above apply. First, investors need to ask whether the credit ratings are actually appropriate and objective. Second, packaging “AAA” and below-investmentgrade credits into a highly rated entity is much riskier than holding an actual investment-grade corporation. The transparency of the latter greatly exceeds the opaqueness of the former.
Another example of credit-rating follies comes from the Canadian recession in the early 1990s, when a number of corporations, such as “AA”- rated Royal Trust, became insolvent despite their investment-grade ratings. These developments were not surprising to me. As the head of Canadian investments at a large insurer, I was required to take part in the due diligence that the various rating agencies subjected our company to. This process included a review of the various problem credits in our portfolios. But appropriate questions were not asked and problem areas were not identified. This lack of thoroughness led investment team members to question the worth of the ratings of companies that we had held in our portfolios.
Needless to say, the old expression caveat emptor still applies. Sound internal fundamental research has to be the cornerstone upon which investment decisions are made.
Bruce Corneil is senior vice-president, fixed income, and chief operating officer, Beutel Goodman Investment Counsel. bcorneil@beutelgoodman.com
