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The value of a rating (and its effect in the ABS market)

23 October 2017 by Elena Rinaldi

Rating agencies play an important role in the financial markets, with their ratings greatly influencing the fixed income markets in particular. Ratings are a score providing a relative assessment of an issuer or debtor’s ability to meet the scheduled interest payments and principal repayment on the bonds and securities they issue. Such ratings are always subject to change, and indeed they often do change over the life of a bond. In most cases this affects the bond’s price and value.

Below is the spread graph of the 10y Portugal Sovereign Bond. The histogram embedded in the chart shows the upgrades and downgrades in sovereign ratings in notches movement. As you can see the larger the rating change the bigger the impact on the spread, especially if it moves from Investment Grade (IG) to a sub-IG rating. In July 2011 Moody’s downgraded its Portugal rating from Baa1 to Ba2 and the bond sold off significantly causing the spread to gap wider from 611bps to 1050bps in just one week.

 

Source: Citibank, Moody’s, S&P and Fitch

ABS bonds are affected by ratings as well, possibly more so than conventional bonds as different ratings are typically assigned to bonds at each level of the capital structure, and these may be subject to different drivers. ABS ratings are established by reviewing the structure of the deal, the parties involved, the nature and performance history of the collateral, the legal structure and domicile of the Special Purpose Vehicle (SPV) used to issue the bonds, and by analysing the credit enhancement used to protect each of the tranche layers against default. Each agency has its own criteria and assumptions to support each rating level and these are updated periodically in line with the development of the relevant economic cycle and market trends. In addition, ratings on the bonds may also be affected by movements in their respective sovereign credit ratings. An upgrade or downgrade of the sovereign rating could also lead to a corresponding change in the rating of the ABS bonds in that jurisdiction, particularly the senior notes, and especially in lower-rated countries.

LUSI 5 is a Portuguese Prime RMBS deal, launched in 2006 and backed by first lien residential mortgages originated by Novo Banco, formerly Banco Espirito Santo (BES). The bond was rated Aaa/AAA/AAA at launch but by the end of 2014 as a consequence of both performance due to the financial crisis and sovereign downgrades to Portugal, it had been downgraded to Ba1/BB+/BBB+.

The tables below show the changes in the bond rating and in the Portugal sovereign credit rating.

There will usually be some differences in timing among agencies. Usually there are scheduled reviews done every one or two years as well as event driven reviews. In April 2011 for example every agency took an action on both the bond and the Sovereign rating.

Source: Moody’s (equiv.), S&P, Fitch

Positive correlation between the sovereign rating and ABS bonds is also visible in the chart below, showing the cash price of LUSI 5 A and the different upgrades/downgrades in the bond and in the country sovereign rating. However it also shows some examples of non-correlation – either where one agency upgrades whilst another downgrades, or where the sovereign is upgraded and the ABS bond is downgraded, or perhaps where the rating of the ABS bond is changed multiple times within a short period.

Source: BBG, TwentyFour

At TwentyFour, we look at these cases closely as they could lead to unusual price action, up or down. Rating agencies in fact can and do make mistakes sometimes and their mistakes can turn out to be expensive for investors.

In September 15, the sovereign rating saw two upgrades, but meanwhile  LUSI 5 A, was downgraded 4 notches by S&P from BBB+ to BB, then moved back up 1 notch to BB+ 10 days later. The reason for the downgrade was a mysterious update to the agency’s criteria for Portuguese RMBS even though the downgrade report highlighted an ongoing improvement in the transaction’s performance since 2012! The bond was trading at around 86 and plummeted to 82.5 after the announcement. An investor holding €5m value would have made 3.5 points mark-to-market loss as a consequence, equalling -€175k. Furthermore, investors constrained by rating parameters in IG would potentially become forced sellers thereby crystallising the loss.

Then in September this year S&P surprisingly upgraded Portugal’s rating to BBB- from BB+ with a stable outlook. LUSI 5 A traded up three points after the announcement solely due to better sentiment. Usually a one notch movement doesn’t really move the market but three or more notches would cause a reaction. However in this case, the movement from non-IG to IG potentially reopens the investor base to a much broader universe, and this undoubtedly contributed to the price uplift.

Two weeks after the upgrade to IG of the sovereign rating, LUSI 5 A was then upgraded by S&P by 3 notches from BB+ to BBB+. As a result the bonds traded up further three points that week making a six-point price rise in total. Was the rating action fairly predictable? Maybe one notch to match the sovereign upgrade but definitely not three.

Upon further investigation of the associated press release we discovered something interesting. The upgrade wasn’t related to either the improved performance of the deal nor to the upgrade in the country rating. The rationale for the upgrade was given as “an identified error” in how the rating agency treated borrowers in its prior review, and as a result, it imposed a higher default stress than required. In the report the agency stated “Following the correction of this error in our current review, we have raised our ratings on the class A, B, and C notes, and affirmed our rating on the class D notes”.

So the upgrade was a consequence of the correction of a previous wrong assumption…..a correction such as this could make investors doubt the rationale of the previous downgrade, as the update on criteria could likely have been the outcome of that wrong assumption.

In conclusion the value of a rating is massive and it can also be quantified. In our €5m example, an investor who was a forced seller when the bond was downgraded and took a loss would now have missed out on a €300k recovery, all because of a potentially erroneous rating change.

Undoubtedly, credit rating agencies have been at the subject of much controversy since the financial crisis. They’ve undergone substantial criticism, especially because of their importance and influential power. Even though investors now place a far less heavy reliance for their investment decisions upon ratings, they are still central to the core frameworks of most investment mandates and capital calculations. This is not the only case of this type that we’ve seen. Going forward we hope these sort of anomalies are at best few and far between, and preferably not from the three big market movers.

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This material is for information purposes only. Any views expressed are those of the author, and do not necessarily reflect the views of TwentyFour. TwentyFour does not warrant the accuracy or completeness of any information contained herein, and therefore it should not be considered as an indication of trading intent, personal investment advice, or a basis on which to buy, hold or sell any investment vehicle/instrument. As such, TwentyFour accepts no liability for any use, or misuse, of the material in this commentary. This material may not be reproduced, in part or in whole without the express prior written permission of TwentyFour.

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