The Private Use of Credit Ratings: Evidence from Investment Mandates
Ever since the global financial crisis in 2008, credit ratings have been subject to increased scrutiny. The main concern with ratings is related to the role overly optimistic ratings played in facilitating the sale of structured securities such as mortgage-backed securities (see, e.g., Benmelech and Dlugosz 2009). As a result, there have been considerable efforts to remove references to ratings in regulation and rules, including in the calculation of capital requirements for banks, brokers and insurance companies. These efforts have been broad in ambition although often hampered by a lack of alternatives.
This focus on regulation is natural, since a large number of rules include references to ratings (for example, investment grade securities, rated BBB or above, are eligible for favorable treatment under many US federal rules). This has been well analyzed (e.g. Opp, Opp and Harris 2013). However, the original (and still most widespread) use of ratings is not regulatory, but private. Investors and asset managers use credit ratings to classify the risk of fixed income assets. Little has been known about how private investors have changed their use of ratings since the financial crisis.
In our new ECGI working paper, we examine the private use of credit ratings in investment mandates of U.S. fixed income funds (which manage more than $7 trillion). In these investment mandates, asset managers demarcate the set of investable assets, often with the help of credit ratings. Ratings thus constitute a key technology for delegated asset management. The asset manager Blackrock describes the function of credit ratings in investment mandates as follows: “References to ratings in investment guidelines play an important role in ensuring that end investors’ expectations with respect to how their assets should be managed are clearly communicated”. At any given time, there exist hundreds of thousands of fixed income assets (many more than the number of equity securities available in public markets), and ratings-based mandates allow managers to communicate (and commit to) risk levels vis-a-vis asset owners such as retail investors, endowments, pension plans, and financial institutions.
Our methodology consists of collecting electronic filings for US fixed income mutual funds and using text analysis to quantify the reliance on ratings. We examine both direct references, through terms such as "BBB", and indirect references, through terms such as "investment grade" or "high yield". Using a sample of mandates from 2010-2017, we document widespread references to credit ratings. For example, the majority of mandates either refer to a specific credit rating agency, a specific alphanumeric rating, or both. On average, 88% of mandates refer to “high yield”, “investment grade”, or other indirect terms. Perhaps surprisingly, we also find that the use of ratings has increased over time. For example, indirect references have increased from 84% to 90% over the 2010-2017 period. This increase is statistically significant and it is also present within a fixed set of funds. In fact, the increase reflects both (i) that funds without references are more likely to close, (ii) that new funds are more likely to refer to ratings, and (iii) that existing funds much more often switch toward using ratings than away from it.
Most fixed income asset classes were not directly implicated in the mistakes that fueled the crisis. For example, think of corporate bonds, municipal bonds, and, indeed, some kinds of structured assets: credit ratings appear to have reflected the underlying credit risk of these asset classes reasonably well, both before and after the crisis (e.g., Cornaggia, Cornaggia, and Hund 2017). Regulatory reforms have not distinguished much between these types of assets, but perhaps private contracting works differently and distinguishes between potentially problematic and useful ratings? We find small differences across asset types (although structured assets are less important in mutual funds, so we can say less for this area).
We examine a more limited sample of investment mandates going back to 1999. While we cannot reject a non-increase in ratings use before the financial crisis, we can do so in the period since the crisis. In other words, the increase in (the private) use of ratings has gone from high to almost universal after the financial crisis!
In our paper, we discuss the implications of this finding. Most importantly, we suggest that the success of ratings in private contracting should give reformers pause: perhaps adequate substitutes are not easy to find. Furthermore, in broad terms, a comprehensive view of credit ratings should acknowledge that, while flawed, and in a few instances dysfunctional, ratings remain a successful system for organizing fixed income markets. On the other hand, any disadvantages related to the use of ratings are important, given how widely used they are.
Benmelech, E., Dlugosz, J., 2009. The credit rating crisis. In: Acemoglu, D., Rogoff, K., Woodford, M. (Eds.), NBER Macroeconomics Annual 2009, Volume 24. University of Chicago Press, Chicago, pp. 161-207.
Cornaggia, J., Cornaggia, K., Hund, J., 2017. Credit Ratings Across Asset Classes: A Long-Term Perspective. Review of Finance 21, 465–509.
Opp, Christian, Marcus Opp, and Milton Harris, 2013. Rating agencies in the face of competition. Journal of Financial Economics 108, 46-61.