Bond Buyers Easing Rating Requirements to Shop for More Deals

Institutional investors are rewriting their old rules so they can buy bonds assigned credit ratings by a broader variety of firms, according to Kroll Bond Rating Agency Inc. and Morningstar Inc.

Over the past year, more than 30 investment firms have eased internal guidelines that limited them to bonds rated by at least one or two of the top three graders: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, said Kim Diamond, Kroll’s head of structured finance.

The loosening comes as some of the biggest bond buyers vocalize frustration that the so-called Big Three ratings firms are being hired less, resulting in fewer bond offerings from which they can choose.

“Issuers want more viewpoints out there,” said Vickie Tillman, president of Morningstar’s ratings unit.

The number of bond deals rated by just Kroll this year has jumped to more than 120 from 30 at this time last year, according to the company. Morningstar also is being hired more. Its ratings of commercial-mortgage bonds, for example, have grown 173 percent since 2012, according to the firm.

Less established graders have made “meaningful competitive inroads” in asset-backed bonds, according to a U.S. Securities and Exchange Commission staff report that was presented to Congress in December.

Big Three Raters

That’s not to say the competition has threatened the dominance of the big three ratings firms, which had issued 96.6 percent of all grades on securities outstanding through 2013, the SEC said.

According to the U.S. government’s Financial Crisis Inquiry Commission, investors historically relied on credit ratings because they didn’t have the same data as the graders or the analytical ability to assess deals. Legislation in the 1980s mandated certain state and federal institutions to only buy bonds if they were graded by at least one of the ratings firms.

“It put them in the business forevermore,” former bond trader Lewis Ranieri told the crisis commission, according to its 2011 public report. Ranieri is widely considered to have created the some of the first mortgage-backed securities while at the now-defunct investment bank Salomon Brothers in the 1970s.

“Moody’s credit ratings are widely sought by investors not because they are required, but because they have proven to be a trusted and reliable source of information on credit risk,” said Tom Lemmon, a spokesman for the firm.

Fitch “had to prove its track record over many years and numerous cycles before most investors added us to their guidelines,” said Daniel Noonan, a spokesman for the firm. “And they only added us because they had developed confidence in our analysis, methodologies and research.”

A spokeswoman for Standard & Poor’s declined to comment.

Fighting Inertia

Funds under Fidelity Investments, which oversees $269.5 billion of bonds, now do their own credit work to determine whether to buy a bond, severing their reliance on credit graders, according to Bill Irving, a portfolio manager at the Boston-based firm.

There are plenty of good deals that aren’t rated by Moody’s, Fitch or S&P, Irving said.

But it may take time for the industry to lift its old policies. “There is inertia in the process,” he said.

At least nine of the largest investment-grade bond buyers have appealed to regulators in recent months to monitor the competition among ratings firms as they find themselves shut out of more deals, Bloomberg reported.

Underwriters seeking maximum investor participation in bonds also have become frustrated with the “antiquated” restrictions, Deutsche Bank analyst Ashley Hooper wrote in a May report on the market for commercial mortgage-backed securities. Ratings competition has heated up substantially in that market as well this year.

Investors who’ve been able to update their guidelines have included hedge funds, asset managers, banks’ investment arms, and even three pension funds, according to Kate Kennedy, a spokeswoman for Kroll.

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