The Bond Market's Shaky Foundation

Erratic Ratings

You don't have to believe in collusion between debt underwriters and the ratings agencies, however, to worry that the system isn't working. The criticism here is coming from bond professionals who have produced a series of studies showing that pools of debt called CDOs (for collateralized debt obligations) aren't showing the patterns of return and default that their credit ratings predict.

For example, one study shows that tranches of CDOs with the same BBB credit rating, which should trade at roughly similar prices, are instead trading at yields that differ by anywhere from 1.4 to 10 percentage points. At the A and BB levels, the gap is something like 4 percentage points. The U.S. Federal Reserve recently weighed in with a paper that said the ratings for CDOs are riddled with "anomalies."

There couldn't be a worse time for the market to lose confidence in credit-quality ratings. Not only has the debt boom flooded the market with billions, indeed trillions, of new debt, but much of this debt is astoundingly complex. Many buyers know they don't have the in-house capability to analyze these instruments. They really have no choice but to trust the ratings or stop buying.

And many of the most recent debt issues offer debt buyers very little protection if they get the initial risk assessment wrong. Some fall into the category of "covenant lite." These debt issues don't include the usual protections for buyers that prevent a company from issuing more debt if sales fall, for example. Others are very explicit about the ability of the borrower to issue more debt if the company gets into trouble.