The Triple-A Rating: Going Extinct?
The AAA credit rating, the gold standard in corporate finance, isn't just an endangered species. "It's almost extinct at this point in Corporate America," says Nicholas Riccio, managing director of Standard & Poor's Ratings Service.
On Mar. 12, Standard & Poor's took the prized triple-A rating away from General Electric (GE). The move, from AAA to AA+—still at the upper echelon of corporate credit quality—was widely expected by fixed-income investors, who fretted for months over GE's exposure to bad debt through its GE Capital arm.
GE still holds its top Aaa rating from S&P's rival, Moody's Investors Service. But Moody's already put GE's rating under review for possible downgrade—a stance the ratings agency reiterated Feb. 27 even after GE cut its dividend to save the conglomerate $9 billion per year.
Just Five AAA Holders
The downgrade leaves just five U.S. nonfinancial companies with the top credit rating from S&P. The triple-A rating seems secure at ExxonMobil (XOM), Johnson & Johnson (JNJ), Automatic Data Processing (ADP), and Microsoft (MSFT). Pharmaceutical giant Pfizer (PFE) also holds a triple-A rating, but on Jan. 26 S&P put the rating on watch for a possible downgrade, after Pfizer said it would borrow $22.5 billion to buy rival Wyeth (WYE).
"We have seen a thinning of the ranks in the last three decades," Riccio said in an interview with BusinessWeek, which like S&P is a unit of The McGraw-Hill Companies. At the end of 1994 14 companies had triple-A ratings. Go back far enough, and now-troubled companies such as General Motors (GM) and Ford (F) had perfect ratings.
Companies enter the triple-A elite only when ratings agencies determine they have, in Riccio's words, "extremely little risk of default" on their debt. Thus, investors feel comfortable lending to Microsoft or Johnson & Johnson at lower interest rates. That lowers the companies' financing costs.
But ask fixed-income experts about credit ratings, and you'll find a lot of skepticism. Sometimes credit investors simply don't trust a company's rating, especially after the credit shocks of the past year-and-a-half.
Based on the elevated yield spread of GE's bonds over risk-free Treasuries, "the market was telling you that GE was not a triple-A company several months ago," says James Barnes, fixed-income portfolio manager at National Penn Investors Trust Company.
Complaints About Ratings
Ward McCarthy, of Stone & McCarthy Research Associates, says rating agencies have missed major problems with corporate balance sheets, most notably the bad debt that led to enormous problems at insurer American International Group (AIG) last year. "The bottom line is that investors cannot rely on the ratings to anticipate when a company is going to have problems," McCarthy says. "There are a lot of dead soldiers that are former triple-A rated companies."
Amid a credit crisis and severe recession, Barnes doubts that it's possible for almost any company to meet triple-A's exacting standards of almost zero chance of default. "These days," he says, "it's hard to view any company and be comfortable taking that position."
Many companies' bonds are "not trading anywhere close to their underlying credit rating," says Bill Larkin, fixed-income portfolio manager at Cabot Money Management. "If you were using that as a guide, you would make lots of mistakes." He says investors have learned they need to do a lot more homework than simply looking up a company's credit rating.
S&P'sRiccio defends the ratings process, saying agencies and markets "may be focusing on different things." S&P puts its focus on "fundamental analysis" of a company's long-term prospects. A triple-A company is one "you don't have to think about," Riccio says. "It has a commanding presence in all its businesses," with little debt and "stability of earnings and cash flow."
Despite complaints, ratings "are still widely used in the marketplace and still respected," says Barnes, who adds they serve as "a starting place to view a company."
Scarcity in Triple-A Debt
Increasingly, however, the triple-A rating is becoming irrelevant to many investors. For one thing, it's too rare. Now that GE has been kicked out of the triple-A club, investors will find it hard to find any supersafe triple-A debt to buy. GE is a heavy borrower, with $524 billion in short- and long-term debt on its balance sheet at the end of 2008. Microsoft, meanwhile, had just $2 billion in debt at the end of 2008, while Johnson & Johnson owed $12.8 billion and ExxonMobil $9.4 billion.
"GE was the only [triple-A rated company] that had debt you would come across" as an investor, says Barnes, who owned GE debt. Now, "you really don't think about triple-A ratings anymore."
Also, many, including S&P's Riccio, doubt new companies will be joining the triple-A club anytime soon. Microsoft, when it won its AAA rating last year, was the first to do so in a decade. GE had maintained its triple-A rating since April 1956. ExxonMobil's rating dates from July 1949, when its predecessor, Standard Oil of New Jersey, won the triple-A honor. "That space is just too hard to get to," Riccio says. "There may be companies with the ability, but there won't be companies with the willingness to do that. Companies aren't willing to manage their finances that conservatively."
Of companies that lost a triple-A rating, Riccio estimates about 60% did so as a result of tough business conditions. But the rest gave up their top rating because they preferred to take more risk—perhaps by taking on more debt or making a big acquisition. "Credit quality has diminished in the last three decades," Riccio says. Companies are "willing to take on more risk."
Boosting Credit Quality
The easy credit of the past decade meant companies with lower ratings could still get financing. The credit crisis has changed that. "There is a lot of downgrading going on right now," Riccio says. But he expects companies may begin to put more emphasis on boosting credit quality. "Once the dust settles, you'll see a little bit of a flight to quality," he says.
After the credit crisis, investors and companies are likely to change the way they view the triple-A rating, experts say. "It will always be something to aspire to," McCarthy says. "The companies that genuinely earn it are a cut above, but clearly there have been some companies that were carrying it and didn't deserve it. As a consequence, we're going to see a change in the way ratings agencies view companies and also in the way the markets view ratings agencies."
The past year has made clear how difficult it is for any company to fully insulate itself from major economic and financial shocks. Top credit ratings may be harder to get, but, to spooked investors, they will be increasingly precious.