Rating Rules Mean Black Fridays for Bond Volatility
Bond traders, check your calendars before heading off for the weekend.
Some Fridays will become more volatile for fixed-income investors as European Union rules implemented yesterday require rating companies to publish a calendar of dates for reviewing the sovereign credit of countries. Until now, the notices have come at random times and on random days.
Assessors will be restricted to three judgments per year on the creditworthiness of sovereign borrowers that haven’t asked or paid for a score. They will also have to give all government issuers a full working day’s notice of any change, and review ratings at least every six months. Increased speculation before the announcements, along with a greater risk of leaks, may make bond markets more volatile even as the regulations seek to boost transparency, investors and strategists say.
“It does make them more volatile on the day and less volatile on the other days because you’re taking away the potential for rumors,” said Stuart Thomson, chief economist and a fund manager at Ignis Asset Management in Glasgow, which oversees 69 billion pounds ($107 billion). “The political pressure on the rating agencies has intensified as they’ve taken decisions that are uncomfortable for European officials.”
The three biggest companies, Moody’s Investors Service Inc., Standard & Poor’s and Fitch Ratings, cover about 95 percent of the world market, according to a memo from the European Commission in Brussels. Lawmakers are concerned about a perceived lack of transparency in decisions that have “immediate consequences on the stability of financial markets,” the Jan. 16 report said.
Investors often ignore rating and outlook changes. Ten-year gilt yields fell from 2.11 percent in the three months following Moody’s cut of Britain’s rating to Aa1 from Aaa on Feb. 22. The yield dropped to 1.61 percent on May 2, and was at 2.33 percent as of 8:17 a.m. London time.
Rating changes for nations close to the boundary between investment and non-investment grade will cause greater market reaction, according to Soeren Moerch, head of fixed-income trading at Danske Bank A/S (DANSKE) in Copenhagen. Spain is rated one step above non-investment grade at both Moody’s and S&P. Italy is ranked within three levels of junk at all of the largest three companies, while the Netherlands has top grades.
“I’d say we’re probably going to have less rumors but increasing volatility going into these,” Moerch said. “The problem that we have with Spain and Italy is that a further downgrade could take them into junk. There’s a big difference between having a rating calendar for the Netherlands than for Spain, when you know that if Spain goes one notch more, they go down to junk.”
Ratings companies will have to publish their announcement calendars for the year ahead at the end of December, with the first schedules due at the end of this year. Issuers will be notified of their new level at least one full working day before the announcement. Publication of sovereign ratings will only be allowed on Fridays, either after markets close or at least one hour before trading starts in the European Union.
French 10-year bonds slid in the hours before the nation lost its top AAA rating from S&P in January 2012 amid speculation a move was imminent. After the bond market closed that day, the then Finance Minister Francois Baroin confirmed to France 2 television that the cut would occur, before the rating company delivered its announcement. The 10-year French yield rose four basis points to 3.09 percent on the day of the downgrade, and is currently at 2.30 percent.
The limits on rating frequency only apply to sovereigns that have not requested a grade. Fifteen of 128 sovereign ratings at S&P, including Italy, the U.S., U.K. and France, are designated as “unsolicited,” according to the company’s website. Additional announcements, and deviations from the schedule, may be allowed if the firms can justify them to regulators.
The raters drew criticism in the wake of the financial crisis for failing to assess creditworthiness in a timely and accurate manner. The new rules seek to address the “insufficiently transparent” reasons for government credit downgrades, according to the EC.
“Credit-rating agencies will have to be more transparent when rating sovereign states and will have to follow stricter rules, which will make them more accountable for mistakes in case of negligence or intent,” Michel Barnier, the EU’s financial services chief, said in January after the European Parliament approved the curbs.
Fitch, Moody’s and S&P all registered with the European Securities and Markets Authority, the regulator that oversees the industry, in 2011, becoming directly supervised by a single EU regulator for the first time. In the past month, ESMA approved the Economist Intelligence Unit and Dagong Europe Credit Rating Sri.
“It is too premature at this juncture to determine its potential market impact,” said Daniel Piels, a spokesman for Moody’s in London, said yesterday. “Moody’s will comply with our obligations and remains focused on delivering insightful credit analysis to the markets.”
S&P expects the regulations to “further strengthen confidence in the integrity and transparency of credit ratings,” spokesman Mark Tierney in London said yesterday. Fitch global head of corporate communications Daniel Noonan said this week that it plans to fully comply with the rules.
“This is just one example of attempts to corral the rating agencies into making more decisions which the politicians would like,” said Ignis’s Thomson. “For us, it has been remarkable that with the weight of evidence against Spain, they haven’t downgraded it. We can only ascribe that to considerable political pressure.”
The new regulation may help investors to avoid volatility according to Peter Chatwell, a fixed-income strategist at Credit Agricole Corporate & Investment Bank in London.
“If we have a calendar it gives investors an opportunity to reduce their risk around these times if they don’t want to be involved,” he said. “Rather than them being forced sellers on the news, they could reduce their risk in a more controlled manner. You might see volatility ahead of the announcement, but the reaction on the announcement would probably be smaller.”
Volatility in U.S. Treasuries as measured by the Bank of America Merrill Lynch MOVE Index has climbed to 86.89, the highest in a year. It has averaged 62.2 during the past 12 months, and dropped as low as 48.87 last month.
The legislation is the EU’s third round of rule-making for ratings companies since the 2008 financial crisis. “Ratings are not just simple opinions,” and raters can be held liable if investors and credit issuers suffer losses because of malpractice or gross negligence in the drawing up of assessments, according to the EC.
The new rules “create expectations for more volatility among investors,” said Lena Komileva, managing director at G+ Economics Ltd. in London. “It is a form of financial protectionism that may increase the cost of credit in euro capital markets, by diluting and possibly distorting the role of independent ratings and putting more pressure on the research resources of each individual investor.”
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