For decades, a popular maxim on Wall Street has been, “as GM goes, so goes the economy”. If that’s the case, then the economy was off to a bumpy start this year: in the first three weeks of 2005, spreads on General Motors Acceptance Corporation’s 7.75% notes due 2010 gapped out a massive 89 basis points to 327bp over Treasuries. But by the end of the fourth week, the same bond had seen a dramatic reversal of its prior fortunes to close at 280bp over Treasuries, according to MarketAxess. During that fourth week of January, however, there was not only a conspicuous absence of positive headlines for the beleaguered auto manufacturer or its financing arm to prompt such a tightening, but also little in the way of economic indicators to imply that GM’s proverbial relationship with the economy had been reversed.
Instead, the U-turn on GM’s bonds was due to GM’s BBB credit rating from Fitch, the smallest of the ‘Big Three’ rating agencies after Standard & Poor’s and Moody’s Investors Service. Fitch’s rating on GM had not changed since a downgrade in October 2004, nor had Fitch expressed any intention to downgrade or review the automaker’s rating in the months to come. But with the announcement that from July 1, ratings from Fitch, in addition to those from Moody’s and S&P, would be used to calculate index quality in the Lehman Brothers indices, Fitch’s opinion on General Motors and a raft of other credits had won newfound importance for fixed-income investors.
Fitch’s management team—Stephen Joynt, Robert Grossman, Nancy Stroker, Paul Taylor, Gloria Aviotti and Peter Jordan—express delight at the development, describing it as a long-expected affirmation of Fitch’s place among the upper echelon of the rating agencies. At the same time, they agree that inclusion in the eligibility criteria for the most established and widely-used fixed-income indices in the world, used by 90% of North American fixed-income investors, is undoubtedly a bonus for the company, thrusting Fitch onto the radars of hundreds of investors and debt issuers not yet familiar with their ratings or research.
But reputations are not built overnight, and while inclusion in the Lehman index criteria is certainly important, it does not make a rating agency, especially in an industry renowned for its lack of competition and its barriers to entry. Instead, Joynt and his colleagues agree that the firm has spent years working to win the kind of investor acceptance that the more established agencies S&P and Moody’s enjoy, and that eventually investor acceptance was a driving force behind their inclusion in the Lehman indices.
Paul Taylor, Fitch’s director of European operations, describes the effort as a continuing struggle. “We have to fight harder to get recognition and to be seen by market participants as providing value,” he says. “We can’t just rest on our lead position because we don’t have a lead position yet.” Nancy Stroker, the agency’s director of corporate finance ratings and with the firm since 1990, cheerfully adds that the group won’t rest then either.
Although Fitch was founded in 1913 as the Fitch Publishing Company—making Fitch almost as old as Moody’s and S&P—the history of Fitch Ratings as we know it today is perhaps better traced back to 1989. In that year, a new management team, including the firm’s current president and chief executive officer Stephen Joynt, recapitalized what was a flagging second-tier agency with a nationally-recognized designation from the SEC, and set about expansion and competition with the top two agencies.
Robert Grossman, who joined Fitch just a few weeks after Joynt and is today Fitch’s chief credit officer, says, “It was a good time to do it: we were only two years out of the stock market crash and there were a lot of very good people available to join us. We started out with around 45 people, and ended the first year with 125.”
Despite aspirations as a full-service rating agency, in the early years Fitch saw its primary growth in the structured finance area, both in terms of coverage and reputation. At the time this was a relatively new market where investors were more likely to be receptive to new ideas, new opinions and a new rating agency. Michael Gray, head of credit research at Credit Suisse Asset Management, says, “Fitch has always been an important provider in the utility, finance and structured space. But in the general industrial space over the last few years, they’ve matured, increased their coverage universe and gained investor acceptance.”
Part of the growth Gray describes was the result of a series of acquisitions that strengthened coverage in the corporate, financial institution, insurance and structured finance sectors, as well as adding international offices and affiliates. In 1997, Fitch merged with IBCA Limited, headquartered in London and part of the French financial services group Fimalac, a move that Joynt describes as the first step to becoming “an alternative global, full-service rating agency capable of successfully competing with Moody’s and S&P across all products and market segments”. Three years later, Fitch followed up the merger with the acquisition of Chicago-based Duff & Phelps Credit Rating Company and, later that year, the acquisition of Thomson BankWatch’s rating business.
Taylor, with Fitch since 2000’s acquisition of Duff & Phelps, says, “We were driven by uniting the middle tier of the ratings industry, which were just competing among themselves, so we could build a platform to compete with S&P and Moody’s. Together with the knock-on effects of growth in the market we operate in, the result has been a 300% growth in the last five years.”
Today, Fitch has over 850 analysts and at the end of 2004, rated 70% of worldwide debt based on issuance volume. In North America, Fitch rated 60% of corporate, financial and public issuance, representing 75% coverage of the corporate market, 67% of public debt issuance and 60% of structured finance.
Peter Jordan, Fitch’s group managing director for global business development, says, “We’ve always had a strong presence in the structured finance market, but our coverage of corporate and public finance issuance has grown dramatically over the last five years in particular. We now rate around 90% of the investment-grade corporate market and, last year, our high-yield coverage was about 20–25% of 2004 new issuance.” Jordan adds that in high yield, the firm currently covers 80% of the top 100 high-yield issuers and is looking to expand coverage of smaller issuers in the year ahead, committing more analysts and more resources to the area.
A crowded market
Efforts to provide greater breadth and depth of research, whether through organic growth or through acquisitions, have necessarily gone hand-in-hand with efforts to gain recognition and acceptance as a third provider of ratings and research in a market already flooded with information from market movements, sell-side analysts, rating agencies and independent research companies. Fitch not only competes with Moody’s and S&P but an increasing noise level around the corporate credit markets, as well as growing internal research efforts in institutional investment firms.
Grossman says that Fitch’s approach to this has always been based on “more research, more transparency and greater investor focus. Those were our watchwords when we started and they stay with us to this day. Investors are and remain the most important constituency for our firm.”
To win investor attention, says Grossman, there was an effort to ensure that research was as forward thinking, innovative and relevant to investors as possible. One of the first examples of this, in 1990–1991, was the development of a new mortgage default model. Up until that point, many mortgage analysts in the market had been using performance data on mortgage securities during the Great Depression, considered the worst-case scenario. “But we thought we could do something a little more relevant,” says Grossman, “so we looked at Texas during the mid-1980s, a period that was not as bad as the depression, but certainly more germane at the time.”
Grossman, whose credit policy group reviews the timeliness and accuracy of ratings, says that analysts often undertake research for internal purposes which is then expanded for external distribution to investors, the attitude being that if analysts find it useful, investors will too. He explains that Fitch recently published a report that began as an internal policy guide on how analysts should treat corporate disclosures of internal financial controls, required for all filings since last November according to Section 404 of the Sarbanes-Oxley Act. “Since these were the questions that would be forming our analysts’ opinions, we thought investors could make use of it,” he says.
Fitch has also expanded to compete with Moody’s and S&P’s ancillary products for investors through the Fitch Risk division, which recently acquired Toronto-based Algorithmics. Gloria Aviotti, director for the credit products group, says that the focus for the year ahead is on building the group’s existing quantitative research modeling to the growing complexity of the market, such as the diverse synthetic transactions coming out of the structured finance market. And the group also expresses an interest in expanding its risk data capabilities. Aviotti says, “This idea goes hand-in-hand with a lot of the quantitative work that we do; 80% of that is data driven.”
After successfully grabbing airtime with investors and building up a reputation, Stroker explains that the second element of Fitch’s challenge was to be accepted institutionally. She says, “Some time ago, our ratings growth meant that institutional conventions became important: were we part of the index rules? Were we written into investment guidelines? Did investors need a Fitch rating, or would they just like one?”
With the inclusion of Fitch ratings in the criteria for Lehman’s indices, the process of institutionalization is certainly under way, but many investors agree that it really began with the 2001–2002 crisis in the corporate debt markets. In 2002, corporate defaults peaked at around 16.4%, representing $110 billion of defaulted debt. In 2001 and 2002 combined, total defaults amounted to $188 billion. But in 1990 and 1991 combined, the corporate debt market saw only $36 billion of defaults. For many market participants, the moral of that story was to seek additional checks and balances in the investment process.
Accordingly, Fitch has seen growing inclusion in portfolio investment mandates, regulatory language and index criteria. Fitch’s ratings are now used in a number of capacities, including the iBoxx index, regulation from the National Association of Insurance Commissioners and, since February, the National Association of Securities Dealers’ Trace database.
In October, Merrill Lynch’s index group also announced that from January 1, Fitch’s ratings would be added to the ratings of S&P and Moody’s in the ratings calculation for its indices. Phil Galdi, head of the global index team at Merrill Lynch, says that after an approach from Fitch, Merrill Lynch canvassed investor reaction to Fitch’s inclusion. “We published the proposed set of rules changes for year-end in June, followed by a three-month public commentary period,” he says. “We got a lot of response, most of it on the ratings issue, and found that investors globally were strongly in favor of a move to include Fitch.” The Merrill indices now calculate ratings as the average of Moody’s, S&P and Fitch ratings.
Fitch has also gained traction in entering investment mandates. In September last year, the California Public Employees’ Retirement System (Calpers), the nation’s largest public pension fund, joined others in revising its fixed-income investment guidelines to include the ratings of Fitch alongside Moody’s and S&P. Calpers uses credit ratings in determining the minimum weighted average credit quality of its portfolio. Jordan says that, for the top 188 bond funds, Fitch is now accepted in 70% of portfolio mandates.
In late January, reportedly after consultation with investors and amid considerable volatility surrounding General Motors bonds, Lehman Brothers joined the pack and added Fitch to its index criteria. Taylor says, “Our inclusion in the Lehman index, although a big and very visible step, is the evolution of a process that has been gaining momentum for some time and we expect to see more steps in the future.” Until recently, Moody’s was used as the primary rating for the Lehman indices; Standard & Poor’s was added in October 2003, when the index began using the most conservative rating of S&P and Moody’s.
Investors say that the long-term benefit of including Fitch in the Lehman index criteria is very clear: a third rating simply reduces the influence of any one rating agency, thereby promoting greater stability for the index over time. One study by Merrill Lynch shows that historically Fitch’s ratings agreed with one of either Moody’s or S&P’s ratings 95% of the time. Between Moody’s and S&P, however, there was a much higher proportion of split ratings.
Head of credit research at Credit Suisse Asset Management, Michael Gray, says, “In numerous conversations with Lehman over the years, we and many clients have always reflected that, if logically structured, more expansive inclusion criteria would be better for the market. In practical terms, the move will lend support in terms of volatility and market levels for crossover names and higher-beta names with ratings downside.”
However, it was the timing of the change to Lehman’s index rules that provoked debate. The new methodology assigns each security the middle rating of S&P, Moody’s and Fitch, implying that two out of the three agencies need to rate a security investment grade for the security to be eligible for Lehman Brothers’ Investment-Grade Aggregate indices.
This was of immediate benefit to owners of bonds issued by General Motors, which had taken a week-long pounding in the secondary markets after poor financial results prompted S&P to announce a review of GM’s debt rating, which currently stands just one notch above junk. Under Lehman’s former rules, inclusion in the investment-grade index was calculated according to the lower of the two ratings. A downgrade to junk from S&P would have consigned General Motors to Lehman’s high-yield index, produced considerable forced selling from investment-grade-only portfolios and swamped high-yield investors with supply from America’s third-largest corporate debt issuer.
A lifeline for GM
With the inclusion of Fitch, which gives General Motors a BBB rating, Lehman granted GM’s falling angel an extra wing to prevent it from dropping out of the index. The relief rally was significant. GM’s 8.375% notes due 2033 tightened dramatically during week after the announcement. By the end of the week, the yield margins on GM’s bonds had tightened to trade in the range of 350–360 basis points over Treasuries from wides of 422bp the previous week.
Stroker says, “I don’t think it was a complete coincidence that some very large issuers were getting close to the border of non-investment grade. It simply became a more urgent issue for investors for there to be a little more breadth of view.”
Bonds of other companies on the cusp of investment grade and high yield also benefited on the news, particularly crossover names with an investment-grade rating from Fitch. Based on current ratings, Lehman estimates that roughly 56 securities totaling more than $32 billion in market value will be implicitly upgraded to the investment-grade credit index when the change is implemented. Leading the pack are FirstEnergy, TXU Corp., Amerada Hess, Enterprise Products and EDS, each with more than $2 billion of debt affected. No issuer will be implicitly downgraded by the rule.
Naturally, this is of some immediate interest for fixed-income portfolios with a mandate to track the index or indeed for existing owners of crossover bonds hoping to take profits on the back of a favorable rating from Fitch. However, many investors argue that in practical terms, despite the surprise timing of the announcement, the change is a cosmetic one with no impact on the fundamentals of credits in or out of the index. And at the same time, Fitch’s inclusion is said to have been under periodic consideration for a number of years and was already widely expected in the market.
Craig Ruch, portfolio manager at Credit Suisse Asset Management, says, “Much of the market was expecting the announcement in April and had already begun to position themselves for the change. Lots of interest was being shown in names where the Fitch rating criteria would have included them in the index.” But he adds that there remain “a lot of investment management agreements that stipulate Moody’s and S&P rather than Lehman index criteria, so the impact may be more muted than people anticipate. I expect that over time, the index change will contribute to more clients adapting their agreements to include Fitch, but it will happen mandate by mandate.”
Investors and analysts also point out that the scale of movement from high yield to investment grade was relatively small: fewer than 60 securities joining the US investment-grade credit index out of a base of almost 2,900.
Nevertheless, the move is a boon for Fitch, increasing its visibility with investors benchmarked to the index and with corporate credits in all ratings buckets. For crossover credits, in particular, the chance of getting an investment-grade rating from Fitch may well become an economic issue, a way to gain cheaper financing and access to a larger investor base. But corporate finance group director Stroker says that Fitch has also been rating more double-A and single-B names that are nowhere near the cusp. “Our coverage is likely to grow because I think a lot more people are going to be expecting to see three ratings on corporate bonds, and if there aren’t, investors will ask why not.”
While Lehman’s inclusion of Fitch Ratings has been widely hailed as a welcome third opinion in the index ratings process, the effect of Lehman’s announcement on the corporate bond market raises some issues. For one, a market reaction on that scale based on a technical change to an index rating rather than any material change to fundamentals has underscored the level of influence the rating agencies can have in the investment process.
In February, the Senate Committee on Banking, Housing and Urban Affairs held the latest in a series of hearings by different bodies to discuss the role of the rating agencies. In his written testimony to the committee, Senator Richard Shelby expressed concern at how rating agencies had come to occupy a role as “gatekeepers to the capital markets”, whose ratings can affect an issuer’s access to capital, structure of transactions and portfolio investment decisions. For example, many institutional investors will have to sell a security downgraded to high yield regardless of whether they agree with the fundamental argument behind the downgrade.
This all amounts to a lot of influence for the agencies and raises the question of how the ratings industry has eluded regulation despite mounting concerns about the potential for conflicts of interest in the rating agency business model, where corporate issuers pay for their ratings. At issue is the integrity of firewalls to prevent abuses of the process, such as issuers paying for more favorable ratings, disclosing material nonpublic information or making ratings contingent on the purchase of ancillary services from the agency.
Joynt recognizes that there is a potential for conflict in the ratings business, but argues that Fitch has “built protective policies and practices together with a strong credit culture to avoid the conflicts”. Compensation of analysts, for example, is organized across the whole firm and not around the revenues of internal departments, ratings are assigned by committee to avoid a single analyst having undue influence and Aviotti’s credit products group is physically separate from Grossman and Stroker’s analysts. Stroker adds, “Not all our issuers pay for their ratings, but the analysts don’t know if they pay a lot or little—they are totally unaware of the business issues.”
Joynt and his team say that the most important defense of Fitch’s ratings against these accusations is their focus on credibility among investors. Grossman sums it up, “We show investors exactly what we’re doing: we publish the criteria, the rationale and the research in great detail, giving investors a chance to disagree. Then we back it up by publishing our default statistics every year—that’s our scorecard.”
However, despite Fitch’s achievements, there remains the issue of the lack of competition in the ratings industry. Fitch Ratings was among the three rating agencies, together with S&P and Moody’s, first awarded the SEC’s Nationally Recognized Statistical Rating Organization designation in 1975. Thirty years later, there are still only four NRSROs—Dominion Bond Rating Services was granted NRSRO status in February 2003.
Jim Kaitz, chief executive officer of the Association for Financial Professionals, representing more than 14,000 treasury and financial management professionals, explains that the lack of transparent criteria for the NRSRO designation has created an artificial barrier for entry. “In order to gain national recognition, an agency needs to already be ‘nationally recognized’: it’s unexplainable,” he says.
The SEC is expected to clarify the criteria for NRSRO status when it issues its long-awaited set of proposals for increased rating agency oversight, together with a likely voluntary code of practice for the agencies. Kaitz expresses impatience with the delay. “The rating agencies have flown below the radar for too long,” he says. But Fitch’s Joynt responds to the potential for a changing industry with, “We’re in favor of anything that promotes competition.”