We previously discussed how in a low-interest-rate environment, the basic mechanics of a life insurance company’s General Account do not work.
This current extended low-rate environment, the misrating of investment-grade corporate bonds we discuss in this article, foreign insurance companies chasing yield in the American markets without hedging their currency risk, and a potential drop in the value of the dollar, all pose a significant possibility of systemic risk to our markets.
What is Subprime Lending?
The term “subprime” is essentially a generic term that refers to the credit quality of borrowers who have weakened credit histories and a greater risk of default than prime borrowers. So, at the 10,000 ft. level, subprime lending is simply providing loans to people or entities that are less likely to repay the loan.
Most people are familiar with the term subprime as it relates to the mortgage crisis. To make this clear, as it relates to the purchase of a home, the term “subprime” refers to the credit quality of the mortgage borrower as determined by consumer credit-rating bureaus like FICO, Equifax, and Experian. Subprime borrowers have lower credit scores and are more likely to default than prime borrowers. To provide context, historically, this group includes borrowers with FICO scores below 600.
Subprime loans generally have higher interest rates, poor quality collateral, and less favorable terms thatcompensate for the additional credit risk. Companies securitized these subprime loans into mortgage-backed securities (“MBS”). When the financial crisis hit, these borrowers, and thus these MBS, ultimately defaulted. This is described as the precipitating factor of the 2008 financial crisis.
How Did Subprime Lending Cause the Financial Crisis?
Academics dispute the exact causes of the subprime bubble. Regardless, this is beyond the scope of our discussion. It is not controversial to suggest that whatever the exact causes of the subprime bubble, they are linked to subprime mortgages, and thus their securitizations, being grossly misrated in relation to their actual default risk. The misrating of subprime mortgages led to an inappropriate accumulation of these loans which magnified the default risk further. It might help to think of this as rating risk. I posit in this article that there are echoes of similar rating risk in the Investment Grade Corporate Bond Market.
How Do Corporate Credit Ratings Work?
Corporate credit ratings can address a corporation’s financial instruments (Corporate Bonds) and/or the corporation itself. Credit rating agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings assign corporate credit ratings. Whereas your FICO score is an exact number, corporate credit agencies use letter designations such as A, B, and C. There is also variation in between illustrated by adding lowercase letters, numbers, and/or pluses and minuses. Higher grades represent a lower probability of default.
Agencies also do not attach a hard number to the probability of default to each grade. They instead use descriptions like: “the obligor’s capacity to meet its financial commitment on the obligation is extremely strong,” or “less vulnerable to non-payment than other speculative issues.”
What is an Investment-Grade Corporate Bond Rating
An investment-grade rating theoretically signifies a corporate bond presents a relatively low risk of default. As explained above, corporate bond rating agencies use different designations. So, we will consider Moody’s ratings for example.
Moody’s rates Investment-grade bonds as: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3. The highest-rated Aaa bonds possess the least credit risk of a company’s potential failure to repay loans. By contrast, the low-tier Baa-rated companies may still have speculative elements. Ratings below Baa3 are not investment-grade.
Various rules across several industries limit certain major market participants from investing in corporate bonds rated below investment-grade. This limits the size of the junk/high yield bond market.
I will discuss this in-depth in the future, but it is important to note now that a downgrade of a corporate bond’s rating outside of investment–grade significantly and materially impacts the bond’s: (1) universe of purchasers; (2) liquidity; and (3) value.
Why is There Risk in the Investment Grade Corporate Market?
There is an art to the agency ratings. Thus, there is not a direct correlation to corporate leverage ratios or to the likelihood of default. It might be easier to digest the misrating I describe from a more authoritative source. According to Morgan Stanley, rating agencies misrate approximately 38% of investment-grade corporate bonds based on their leverage ratios. Instead, Morgan Stanley says the rating agencies should rate these corporate bonds junk. Specifically, 27% of investment-grade corporate bonds should be rated Ba, 10% should be rated B, and .5% should be rated Caa based on their actual leverage ratios.
According to the Bond King Jeffery Gundlach, corporations have issued a massive amount of the lowest-rated investment-grade corporate debt since the Global Financial Crisis. He explains, 60% of the $6 trillion investment-grade universe now carries the lowest slice investment-grade rating.
If properly rated, 37.5% of the entire investment-grade corporate bond market would be rated Junk. The relatively small junk bond market ($1.2 trillion) could have a hard time absorbing the potential new supply without sharp price discounts if a downgrade cycle were to occur.
Mr. Gundlach further explains that if companies within the lowest-rated slice of investment-grade debt don’t address their debt levels, or if there is a pullback from the most recent market highs, there could be a significant portion of the investment-grade market being downgraded. This is reminiscent of what happened in the securitized subprime market during the 2008 Financial Crisis.
Similar to the subprime mortgage bubble, a downgrade of a significant portion of the investment-grade corporate bond market could pose a systemic risk to our financial system because the majority of the investment in this market is done by some of the most interconnected companies in the world.
Chasen Cohan, Esq. is the founder of Cohan PLLC. Mr. Cohan is a licensed attorney who also possesses FINRA Series 7 (Registered Representative) and Series 63 (Uniform State Representative) licenses, state insurance licenses, and State Securities Registrations in Nevada, Missouri, and North Carolina. Mr. Cohan is admitted to practice law before the Nevada Bar, all Nevada State and Federal Courts, and the United States Court of Appeals for the Ninth Circuit.
Mr. Cohan’s representative clients have included: Wal-Mart Stores, Inc., Sam’s West, Inc., MGM Grand Resorts International, New York-New York Hotel & Casino, Mandalay Corp., The Treasure Island Hotel and Casino, The Cosmopolitan of Las Vegas, The Mirage Casino-Hotel, South Point Hotel & Casino, American Express, Barclays, US Bank, Wells Fargo, Citibank, and various life insurance companies and service providers.
Mr. Cohan is a Las Vegas native who graduated with honors from UCLA with a Bachelor of Arts degree in Political Science. Mr. Cohan received his Juris Doctorate from the University of Texas School of Law. During law school, Mr. Cohan served as a clerk for the Office of the Texas Attorney General and a Judicial Extern for United States District Court Judge James R. Nowlin.
Clients from global brands and middle-market companies to innovative startups and individuals trust Cohan PLLC to resolve their trickiest legal disputes. Whether that’s litigation in state or federal trial and appellate courts in Nevada; investigations and enforcement actions before government agencies; or mediation, arbitration, and regulatory agency proceedings. Cohan PLLC has litigated hundreds of millions in dollars of claims on behalf of corporate litigants. As a result of this experience, Cohan PLLC has been afforded the opportunity to selectively act as Plaintiff’s counsel on complex, personal injury matters.