Both Fitch and Lehman declined to comment on the move. But market participants say inclusion in the Lehman Aggregate Index could finally allow Fitch to compete with Moody’s and S&P on an equal footing. “More people will take notice if Fitch ratings are included in the Lehman Aggregate,” says one euro-denominated bond investor. “The key change will be when our clients [investment consultants] start to include Fitch ratings in their investment guidelines.”
More importantly for Fitch, corporate treasurers will be more inclined to pay for a Fitch rating if it will allow their securities to be included on the major indices. And investors say the inclusion of a third rating would make for a more stable index, and that increased competition between the ‘big three’ rating agencies is a welcome prospect.
The role of ratings
Ratings are important to index providers insofar as ratings dictate into which rating category a credit should be placed within the index. The issue is most important when a credit is assigned a high-grade rating by one agency and a high-yield one by the other. In these cases, providers of high-grade indices such as the Lehman Aggregate must decide whether the credit should remain in the index.
Until recently, the Lehman Agg favoured Moody’s ratings. It would only use an S&P rating if a security had no Moody’s rating. Last June, however, Lehman decided to weight S&P and Moody’s ratings equally, using the lower of the two ratings. Indices tend to use the lowest rating because of forced selling. Investment guidelines may force some fund managers to sell a credit if, for example, its Moody’s rating falls to junk, regardless of whether it retains its investment-grade rating from the other agencies. If there is a chance that some fund managers would not be able to hold a credit, it isn’t included in high-grade indices.
Despite these changes to its methodology, the Lehman Agg still does not recognise Fitch’s ratings. Lehman is not the only index provider to ignore Fitch ratings. JPMorgan and MSCI indices work along the same principles as Lehman indices, taking both Moody’s and S&P ratings into account and accepting the most conservative. Merrill Lynch indices use both S&P and Moody’s ratings, averaging them out with a conservative bias.
In fact, iBoxx is alone among the major index providers in recognising Fitch ratings. The index has accepted the lowest rating of the three major rating agencies since its inception in 2001.
While Merrill Lynch declined to comment publicly on whether they would include Fitch ratings in their indices, a member of the Merrill Lynch index group says that there is a possibility of Fitch ratings being included in Merrill Lynch indices. “Fitch has historically had limited coverage, but we would certainly not rule out using Fitch in the future,” he says, adding that there have been high-level meetings between Fitch and Merrill Lynch to discuss the possibility.
The source also explains that there is no financial relationship between the indices and rating agencies: “It works on the basis of mutual benefit. The decision ultimately rests on the market’s perception of Fitch’s ratings.”
Indices are important to bondholders. Most institutional fund managers are tied to one index or another by the investment guidelines laid down by their clients, and any major change to the composition of an index compels fund managers to reshuffle their portfolios – incurring unwelcome transaction costs.
Index providers at Lehman and Merrill Lynch say that using Fitch ratings would not drastically alter the composition of their indices. In fact, when Lehman changed its methodology last year to give equal recognition to Moody’s and S&P, only one credit fell out of the investment-grade index. But at first glance, the inclusion of Fitch ratings in indices would seem to threaten greater volatility in the credit markets. Put simply, there would be one more rating agency that could downgrade a security to junk, force it out of the index and therefore compel many institutional investors to remove it from their portfolios.
This would not only be an issue in the crossover area, either: most index providers offer bespoke indices with narrower ratings criteria. A custom benchmark tied to a double-A index, for example, would face the same problem.
But most investors say that three ratings would make for a more stable market, reducing the impact of ‘rogue’ rating actions. “Three ratings would reduce volatility, and actually make it harder for a security to fall out of the index,” says one fund manager.
The inclusion of Fitch’s ratings could encourage index providers to form a consensus ratings view, where the rating opinion most frequently held by the agencies – the mode – is used for the index. The use of a mode could prevent a downgrade from a single agency leading to forced selling. For example, when the British government forced UK rail operator Railtrack into special administration at the end of 2001, S&P responded by downgrading the company from A to C. While Moody’s maintained its investment-grade rating, the S&P downgrade forced almost one-fifth of Railtrack’s bondholders to sell the firm’s securities despite them later being repaid in full. German industrial group ThyssenKrupp has also had a split rating since February last year, when S&P downgraded the credit from BBB- to BB and Moody’s downgraded it from Baa1 to Baa3.
However, any change to consensus ratings would have to be accompanied by a change in asset managers’ investment guidelines so that investors are not forced to sell a credit which remains in the index because one rating agency has downgraded it.
But some index providers are concerned that there is a deeper issue at stake: should indices drive, or merely reflect, the way funds are managed? A head of indices at a major US bank warns: “I don’t like the idea of the index changing, and investors then having to change their strategies.” While he accepts that the overall impact of Fitch recognition would probably be positive for investors, he says: “It’s the wrong way around – it shouldn’t be Fitch lobbying Lehman. If anything, it should be investment managers lobbying Lehman, saying that they use Fitch ratings and therefore want them included in the index, to reflect market practice.”
Lehman conducts a formal consultation exercise with its clients every year under the banner of the Index Advisory Council. This year’s exercise concluded in March. Only those investors in the council hold real sway over Lehman. While Lehman obviously did not decide to incorporate Fitch this time around, sources involved in the consultation exercise say that investor sentiment is becoming more supportive of Fitch’s inclusion.
Cat amongst the pigeons
A more stable index is not the only reason that many investors would be happy to see Fitch included in more indices. A stronger Fitch, they reason, would make the ratings game more competitive. Bernard Hunter, global head of research at UBS Asset Management, says: “We like Fitch – the analysts are very responsive and transparent.”
Fund managers hope that a successful Fitch will force Moody’s and S&P to compete in terms of transparency, as well as price. If Fitch is able to compete on a level playing field, investors hope that the price of rating services across the board will be forced down. Fund managers grumble that Moody’s has raised its fees by around 5% over the past six months. “There is a limit to how much we will pay,” warns one investor.
But from Fitch’s perspective, the focus of competition will be on those corporates entering the bond market for the first time. At present around 100 new firms come to market per year. Basel II will put pressure on companies to rely less on bank debt to finance their operations and make more use of the corporate bond market. Fitch will want to be well positioned to attract new business from these names; inclusion in the major indices prior to the enactment of Basel II in late 2006 will be crucial.
And no matter how successful Fitch’s recent lobbying efforts prove, it will be some time before the process of incorporating Fitch ratings into any index will be completed. Lehman Brothers has 5,000 credits in its index family and Merrill Lynch has 20,000. According to one index provider, including Fitch’s ratings “is not something that can be rolled out over a three- to six-month period; it’s a huge project.