By Dave Brown – Exclusive to Resource Investing News
The power of the three most influential US-based credit ratings have profound and material effects across multiple asset classes and mandates including the price of stocks, the gold price, commodity prices and even the ability for oil and gas companies to raise capital for investment and resource exploration and development. Broader economic impacts can also be linked to confidence metrics including global labour markets, national monetary policies and central banks’ interest rates. Applications of these ratings are used by retail and institutional investors, debt issuers, broker-dealers, and multiple levels of governments for capital investment and policy decisions. Investors might find it a worthwhile exercise to examine aspects of these agencies to evaluate the nature and context of the recent US credit rating downgrade by Standard and Poor’s (S&P) to assess the impact and potential outlook for resource investing opportunities.
A common history
Combined to total approximately 90-95 percent of the market, the three US-based bond rating agencies, S&P, Moody’s and Fitch Ratings share the similarity of a long track record. The oldest is S&P, whose pedigree dates back to 1860, followed by Moody’s which originated in 1909 with scores of American Railway companies, and thirdly Fitch Ratings founded in 1913.
Objectives and roles
The primary role for these agencies is to assign credit ratings for issuers of various debt obligations as well as the instruments themselves and sometimes the servicers of the underlying debt. Generally, the issuers of these securities are companies, national, regional, or municipal governments, non-profit organizations, or special purpose entities, offering bonds or debt instruments for trade on a secondary market. The credit rating for an issuer is designed to consider the issuer’s credit worthiness and affects the interest rate applied to the particular security being issued.
The pseudo-legal and quasi-regulatory position accorded to credit ratings dates back to a time when bond markets were more stable. Many funds and structured products are limited to exposure in certain grades of investments that are predetermined by an investment mandate or policy statement and disclosed in a prospectus or offering memorandum. These statements serve as an indication to the investors of the type of investment and implied level of risk.
This can constrict the value and competitive advantage that could be developed through proprietary due diligence. Mechanical calculations and implied standardized metrics by the agencies meant that stewards of capital and investors did not need to do their own research; instead merely executing investment decisions on an overall rating from the agencies.
The system has often fallen under close scrutiny as the rating agencies have failed, on multiple occasions, to accurately evaluate credit worthiness in order to limit investment loss with material consequence. Obvious examples are cited including Enron, Swissair and Worldcom and most recently the role leading up to the subprime crisis, with what has been observed to be absurdly high ratings given to suspect bonds, Freddie Mac and AIG.
Portfolio Manager of the world’s largest bond fund and Pacific Investment Management Company (Pimco) founder William Gross has gone so far as to urge investors to ignore rating agency judgments, describing the agencies as “an idiot savant with a full command of the mathematics, but no idea of how to apply them.”
Credit ratings agencies have been criticized for having too familiar a relationship with senior executive company management, potentially vulnerable to undue influence pedaling. Conflicts of interest exist in assigning sovereign credit ratings where they have a political incentive to demonstrate stricter regulation by being overly critical in their assessment of governments they regulate. In certain cases they have not downgraded issuers promptly enough, or have even been accused of engaging in solicitation tactics to generate new business from clients, and lowering ratings for those firms. The lowering of a credit score can create a vicious cycle, since interest rates for that company will increase, and other contracts with financial institutions can also be adversely affected, resulting in marginal expense and ensuring a decrease in credit worthiness.
Over the short term, gold prices could benefit from the renewed risk-aversion from the US credit downgrade, in addition to precious metal cousins platinum, silver and palladium. European debt and insolvency is also still a very big question mark in the global financial climate. Meanwhile the immediate demand for energy stores such as uranium, coal, oil and gas are more heavily dependant upon the broader economic context which becomes a function of whether governments, corporations, and individuals move towards a more contracted approach to the downgrade. Any consequential recessionary impact will affect the demand and price for non-ferrous metals such as copper, lead, nickel, zinc, iron, aluminum, tin, tungsten, molybdenum, cobalt, and titanium. Technology metals such as lithium, tantalum, vanadium, manganese and the rare earths could also face the impacts of a potential decline for demand. Relatively strong continued economic growth in China may provide a level of spot market price support, particularly as the world’s top copper consumer and the second largest consumer of oil.
Any implied decline of the creditworthiness of US Treasury bonds suggests that in the future there could be a shortage of AAA investments, and potential inefficient market prices may exist for companies with significant capital to employ leverage. A strong balance sheet can be a tremendous asset for a competent management team in periods of capital market volatility, providing for mergers and acquisition opportunities or additional organic growth from resource development. Investors could look to companies with strong management and good balance sheets in order to exercise these competitive advantages. Consolidation in the resources sector is likely to continue. Certain investors with a particular appetite for risk and the proper investment horizon may find some demonstrated weaknesses as buying opportunities.
Securities Disclosure: I, Dave Brown, hold no direct investment interest in any company mentioned in this article.