Tuesday, 13 July 2010

Whys is AAA not a coveted prize any more ?

Hold your breath, all ye men and women – there are now only four companies in the world which are AAA rated – ADP, Johnson & Johnson, Microsoft and ExxonMobil. That’s it. Why are there so few in this exalted list ?

Before I go further, this is not a “technical” blog. Technically I should be saying companies whose bonds are rated AAA . Short term or long term ? Moody’s or S&P or Fitch ? Is Moody’s rating not Aaa ? Let it go. It doesn’t matter. The point is not to be technically correct. A AAA rating (in whatever form) acknowledges that the company’s bonds (not shares) have the highest degree of safety . Wouldn’t it be something every company would die for ? Obviously not. Only four companies are there. Why so few ?

The recent financial crisis has taken its toll. Quite a few have dropped off the list in the last couple of years. Notably GE, a long time star of that list. Understandable. But this doesn’t explain the paltry list fully.

Some companies deliberately get off the list for strategic reasons. A good recent example is Pfizer. Pfizer decided on a big strategic acquisition in Wyeth. It took a lot of debt on its balance sheet to do the deal. It lost its AAA rating because of this deal, but was perfectly happy to do so. Many companies decide to forgo their AAA rating for a strategic acquisition.

The real issue is the cost versus benefit of maintaining a AAA rating. Bragging rights is all fine, but bragging has little economic value. The real value of a AAA rating is that your cost of borrowing is lower. But to achieve that, you need to meet a number of stringent parameters, including having very little debt on your balance sheet (every one of the four on the list has virtually no debt). Perversely, as a company, if you have all equity and no debt, your cost of capital is high. So what’s the use of lower borrowing costs if you are not borrowing in the first place, or borrowing very little ? Companies decide that the AAA rating is simply not worth the price and therefore don’t aspire for it.

Rating agencies have also become very wary of AAA ratings. Quite a few members on that list have subsequently defaulted !! AIG, once a member of that club, is a good example.

But somehow, it doesn’t seem right that only four companies in the world have the highest degree of financial safety. Is the corporate sector simply too risky ? Or has risk not been priced properly enough to warrant some more companies deciding that the trade off of cost of borrowing and stringency of safety requirements is worth it ? Or does the investment market simply not care for the “highest” degree of safety and is perfectly happy with “adequate” levels of safety ?

So what does the “Scottish widow” (euphemism for the most risk averse investor) do with her money ? Dig a hole in the backyard. Hardly safe. Buy gold ? You must be joking. Put it in a bank ? This is what most widows do, but show me a AAA rated bank. There is just the mistaken belief that there is an implicit sovereign guarantee and that no country will allow a bank to go bust.

I can understand all the logical reasons why there are so few companies at the top, but somehow it seems odd that only four companies in the world are really really really safe financially.


zeno said...

One day, i shall enter politics and shall start a B-School and no prizes for guessing who will be the dean!
BTW, why is investing in gold not a better option in terms of safety?? though the return is very low when compared to stocks

ambulisamma said...

Oh my god,reading your blog just tempts me to go back 2 yrs,since now am absolutely out of my career life.

Anonymous said...

wow...never knew understanding the technicalities of economics and finance wud be so easy..bloggers gain is teaching communities loss. u have a wonderful way of explaining complex things. FIn timesla freelancing journalist or eco expert column antha mathiri try pannungalaen..many wl benefit


Ramesh said...

@zeno - Hopefully you'll start a B-school without entering politics ! Gold is not as safe as it sounds - its actively traded and gold prices are subject to the same levels of speculation. In the short storm you can lose your shirt; in the long run, you may or may not win. Its now no less or no more secure than say property.

@ambulisamma - Understand the feeling; you'll be back soon and in any case you are in a far more satisfying "job" now !

@gils - Humbled. Thalaivar's praise is high praise and thoroughly undeserved.

sandhya sriram said...

i completely agree with Gils. you simplify almost anything. whoseover loss it is, it is definitely our gain that you got to blogging.

it is a tough world out there for investors. i do better things with my money rather than struggling like them --- i spend it :-)

Vishal said...

Probing thoughts on a complex matter in the simplest manner, that is what you do beautifully... :-)

I think it is a mix of both - risk not being priced properly enough to warrant the decision of genuineness of trade off and market being happy with adequate level of safety.

On a different note, the widow not intereted in putting her money in a non-aaa company should not be putting it in any non-aaa bank also if she is a "scottish widow" in real sense :-)

Ramesh said...

@Sandhya - Ha Ha ; that's a such better alternative. Although I know that you don't do that !

@Vishal - To all of us a bank signifies the highest safety; that's why people still put money in dud banks. And governments continues to fuel the misperception of sovereign guarantee - witness Northern Rock in the UK and a few cooperative banks in India. Politically governments have no other choice - which is why I am a strong advocate of splitting up consumer banking from all other exotic varieties. Th first is a utility, with an implicit sovereign guarantee and must be prevented from taking any significant risks. The second can do what it wants, but clearly no guarantees - if they go bust , investors/depositors lose their shirts.

le embrouille blogueur said...

Wow ... I did not even know till now what the AAA means. There is an automobile insurance etc company AAA and I thought this post was about them. Pardon my ignorance. I should be banned from commenting on your blog on business topics. Thanks for the nirv'aaa'na.

Ramesh said...

@blogueur - H Ha. Love your brand of self deprecating humour.
Btw, my beloved nanny seems to have taken a massive dislike to your blog. Yours is the only blog, I can't even open. Will escape the clutches of the nanny in two weeks time - will then catch up with the backlog. Intrigued by Wordless Wednesday - tough to imagine the blogueur being silent !!!

Vishal said...

@ Ramesh - Simply brilliant idea. There should be absolute guarantee for the most risk averse investor too.

Deepa said...

I guess the 'Scottish widow' should sleep with her money under her mattress and pillow. Right now nothing looks safe anyways. For all you know the rating agencies might be playing safe, lest the old harriden sues them for misleading her.

Ramesh said...

@Deepa - Keeping under the mattress is the most unsafe of them all !!! And yes, the agencies are in mortal terror of getting sued - so the pendulum has swung the other way.

j said...

Didn't realize that there were only 4. I was initially surprised that it was so low, but maybe there shouldn't be any companies in that category. It may not be such a bad thing to have a rating level that sets the benchmark for what is super safe while reminding investors that most (all? - I am thinking of BP like surprises) companies are far from it. The reason I say this is there is no absolute definition of what a rating level means and it is fairly subjective. But when faced with the actual rating, somehow there is a sense of preciseness and safety for investors.

Ramesh said...

@J - Yes these ratings are subjective indeed and things can change suddenly, BP style, but then that's true of anything, including countries. Look at investors being ready to consider all banks as AAA; I would rather put money in GE than in Indian Bank !

Anonymous said...
This comment has been removed by a blog administrator.
Anonymous said...
This comment has been removed by a blog administrator.

Follow by Email

Blog Archive

Featured from the archives