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Ratings and the Efficient Market Hypothesis
Von Dr. Oliver Everling | 7.Juni 2008
The „efficient market hypothesis“ is a still-controversial economic theory with implications for rated debt issuers, writes Rod Rumreich, Senior Advisor, Global Investment Advisors, Inc., Carlsbad, California, USA (www.gia-inc.com), in the GIA Bulletin. „The hypothesis says that the market price of a security fully and accurately reflects all available information. Changes in the price of a security are the result of new information in the market. Let’s see if we can relate this theory of market pricing to credit ratings.“
Ratings indicate relative risk of default. That risk is less than 3% over the first five years of the life of a corporate bond initially rated BBB minus. The risk increases at lower ratings. The prices of bonds reflect a variety of factors, states Rumreich, including supply and demand, maturity, coupon, tax status, and liquidity, in addition to non-payment risk. Over time, prices of regularly traded issues will reflect all available information. Ratings, on the other hand, primarily reflect the agency’s perception of relative risk of non-payment and not other factors with which the market is concerned.
When the price of a regularly traded bond is „out of sync“ with its rating, it can be assumed that either the market knows more than the agencies, or the agencies know something the market doesn’t. Some market segments are currently being hit by sub-prime and related mortgage problems, including accelerating default experience in securities backed by mortgages. In these cases, the disconnect between ratings and prices seems to reflect a difference between the agencies‘ expectations for performance of the securities in question and the market’s assessment of the reality of that performance. Agencies generally take note of the difference, but don’t feel the need to „follow“ the market absent new facts.
One reason the rating agencies can have a different rating than the pricing in the marketplace stems from the manner in which ratings are derived, says Rumreich. Rating agencies (1) rely on historical date, and (2) cannot predict with certainty what the future will hold. Nevertheless, the rating agencies are focused on future risk. The analyst is responsible for assessing risk based on historical information and can therefore tell a rating committee what has happened and why. He or she will then extrapolate and derive a set of expectations on a fact-supported basis. This involves estimates and opinions, and is therefore speculative and less easily defended should the projections not be realized. The rating team may then be exposed to criticism from both internal and external sources.
Therefore, argues Rumreich, agencies tend toward conservatism. In addition, the agencies are attempting to inform fixed income investors as to the likelihood of timely payment on their investments. Since fixed income investors are entitled only to what has been promised, upside potential is irrelevant. It’s only the downside risk that matters. The equity market can freely speculate about the „what ifs.“ If things go well, equity holders may reap a profit, but debt holders get no bonus. This fuels the agencies‘ beliefs that they should be especially vigilant in „protecting“ debt investors.
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