Imagine that your doctor’s psychological disposition slanted both his diagnoses and your treatments. A similar effect can happen when analysts rate bonds, according to new research from the McCombs School of Business — and it can help or hurt a company’s financial health.
In recent years, analysts at bond-rating agencies have gotten a bad reputation. They’ve been accused of being too chummy with the firms they cover. They’ve been blamed for helping to bring on the mortgage crash by inflating the ratings of mortgage-backed bonds.
Assistant Finance Professor Cesare Fracassi had yet another cause for suspicion: unconscious biases in their heads.
Fracassi studies the crossroads of psychology and finance, especially in securities markets. Other researchers have looked at the prejudices of stock analysts but none had yet examined bond analysts — although they also wield great power over a company’s fortunes.
That’s because their bond ratings, from AAA down to D, help determine interest rates. The lower the rating, the higher the perceived risk and the higher the rate the corporate borrower will have to pay. “When corporations need to borrow money from the market,” Fracassi says, “analyst opinions are important.”
If an individual analyst leans towards optimism or pessimism, it could bleed through to balance sheets of companies he or she covers, Fracassi suspected. “The cost of capital might be greater when the analyst is pessimistic,” he says.
Since he can’t peer directly into their psyches, Fracassi defines both traits in comparison to other analysts. An optimist tends to give the same bonds higher ratings than do peers, while a pessimist rates them lower.
Comparing bond analysts was not so simple as it might sound, because unlike stock analysts, they don’t author reports. Their names appear only when agencies announce a change in a company’s ratings. So Fracassi built a database of 798 analysts. With colleagues Stefan Petry of the University of Melbourne and Geoffrey Tate of the University of North Carolina at Chapel Hill, he sifted through 44,829 announcements from the three major rating agencies: Fitch, Moody’s, and Standard & Poor’s.
The researchers found differences between rating agencies, with Fitch averaging the highest ratings and S&P the lowest. They also discovered personal biases among analysts, with some consistently awarding higher or lower ratings than others to the same bonds. Separating out the effects of the agencies they worked for, the leanings of individual analysts explained up to 30 percent of differences in ratings.
Those biases made financial differences, as well. If an analyst’s pessimism led to a one-notch rating decrease — say, to AA+ from AAA — it raised a bond’s interest rate by .35 percentage points. The gap jumped to .51 percentage points when ratings were near a key threshold: between investment grade and non-investment grade bonds, which are off-limits for some funds to buy.
Those differences might not sound like much, until you consider that blue-chip corporate bonds are paying 3 percent interest these days. “In today’s low-rate markets,” says Fracassi, “half a percent is a lot.”
So should investors trust optimists or pessimists? His findings favor the naysayers. Analysts with MBAs were 15 percent more pessimistic than those without, and their ratings were more accurate in terms of predicting defaults.
A warning flag for optimism was how long an analyst had covered a company. Every 10 years of coverage raised their ratings by one notch, while decreasing their accuracy. “There’s a concern that after a while, you become buddies with the CEO,” Fracassi says. “You start to become more lenient.”
Both Moody’s and Standard & Poor’s, he notes, have recently set limits on how long analysts could cover the same firm.
For investors, Fracassi’s message is clear: Buyer beware. “Don’t believe everything that the rating agencies tell you,” he says. “Do your own due diligence on bonds before buying them.”
That includes due diligence on the analysts who are rating the bonds, too. It’s hard for the average investor to figure out an analyst’s biases and adjust for them, but investors can get clues by reading resumes on websites like LinkedIn. Positive signs are an MBA and long tenure with an agency. A minus is a long span of time covering the same company.
Corporations, too, have an interest in bias — of the positive sort, since a kindly rating can translate to lower borrowing costs. “If you have any influence over who is going to rate your debt,” Fracassi says, “you want to have a more optimistic analyst.”
Does Rating Analyst Subjectivity Affect Corporate Debt Pricing is published in the Journal of Financial Economics.