Some of the world's largest asset managers are cutting ties to credit rating agencies, potentially signaling the beginning of the end of their grip on global financial markets.
Managers responsible for billions of euros of fixed income investments are reviewing relationships with the likes of Fitch Ratings, Standard & Poor's and Moody's Investors Service [MCO 35.27 -1.18 (-3.24%) ], whose calls on Portugal, Ireland and the United States have roiled central banks desperate to avert a collapse of the Euro zone.
Fund firms contacted by Reuters said rating agency research tended to be backward-looking and superficial, and often encouraged the kind of speculation that has recently dragged down Italy, one of the world's largest government bond issuers.
"We have cancelled our subscriptions to two of them and they haven't left us alone since. It has been very irritating," the head of sovereign debt investment at one large European bond investor told Reuters on condition of anonymity.
"It would be naive to blame the agencies for everything that went wrong during the financial crisis but anyone who relies on a third party to form their investment opinions is headed for trouble ... clients pay us to make those decisions, it would be completely wrong of us to abdicate that responsibility."
Investors say they have steadily reduced reliance on external research providers ever since rating agencies slapped high ratings on complex structured financial investment products such as collateralized debt obligations (CDOs) which later turned out to be far riskier than initially assessed.
A broad push for development of proprietary research teams shows credit ratings agencies have never fully regained the trust of some of their most important buy-side clients, some of whom are still counting the costs of belated warnings of a change in the risk profile of debt issuers.
Relations have cooled even further in 2011 as the increasing probability of a European sovereign debt default threatens to kick a feeble economic recovery sharply into reverse.
European Commission President Jose Manuel Barroso has said Europe was looking at ways to curb the power of the mainly U.S. based agencies and was weighing possibilities for legal redress after Moody's downgrade of Portugal's debt.
"Ultimately, we believe that the research which we produce 'in-house' is more detailed, more forward looking and timelier than that of the agencies," Garrett Walsh, head of credit research, Europe and Asia at Pioneer Investments told Reuters.
Pre-crisis, Pimco, the world's largest bond investor, used to limit its own internal ratings to private corporations. In 2008 it extended this to Western sovereign credits and now runs its own internal ratings system for all issuers of debt.
"We will compare our rating to the external ratings but we try to make our decision independent of what the major rating agencies are saying and that has certainly accelerated," Andrew Bosomworth, head of portfolio management in Germany at Pimco, told Reuters.
"We know what's inside what we rate," he added. Daniel Noonan, a New York-based spokesman at Fitch said his company advised investors to use its ratings and commentary alongside a range of inputs when making investment decisions.
"We think over-reliance on any single input, including a credit rating, is unwise. We continue to see strong demand for our opinions and products, and as a result our business is growing," he said.
"Investors are undoubtedly doing more of their own research, which we think is appropriate. However, they still need benchmarks to support their research efforts," added Michael Privitera, a member of S&P's Valuation and Risk Strategies team.
Passive Problem
While credit rating agencies may be losing influence on the investment decisions of the world's largest asset managers, sudden ratings calls can still trigger massive sell-offs from passively-managed funds which track an index whose composition is shaped by the ratings given by the credit agencies.
When a country's debt is downgraded below investment grade it is pushed out of an index, forcing passive investors to sell their holdings and crystallize hefty losses that could shrink when the immediate rush for the exit subsides.
Sylvain de Ruijter, head of core fixed income investments at ING Investment Management, said many managers were seeking greater freedoms to change their benchmarks to insulate passive funds from sudden ratings actions which could strip millions of euros off the value of their client's investments.
"Mutual fund managers can decide at any time to change a benchmark if he or she believes that is in the best interest of the client. For passive funds, you will have to inform all your investors and distributors and change the prospectus but if you feel strongly there is benefit to doing it, it can be done."
Some investors say credit default swap prices — the cost of insuring debt against default — are a much better measure of risk than credit ratings.
Data from Markit showed the 5-year CDS rate for Irish debt, for example, had shot up more than 220 points to more than 940 in the week ending July 8 — the week before Moody's slashed the country's credit rating to junk status, warning the debt-laden country would likely need a second bailout.
"Our approach seems to have quite a high correlation to 5-year CDS index which is a decent measure of value in bond markets and a much greater correlation than rating agencies have. In general markets tend to move ahead of rating agencies," BlackRock's Ewen Cameron Watt said.