That’s So Overrated: How Credit Ratings Do Damage by Jeff Skoglund, AllianceBernstein.

Credit rating agencies are a capital-markets fixture; the ratings they assign to the debt of corporations and governments are widely used by investors as a standard measure of credit risk. But agency credit ratings aren’t perfect—and shouldn’t be a substitute for investors doing their own analysis.

Ratings that are too generous can have negative consequences. The ratings that agencies give help determine how easy—and expensive—it will be for a company or other debt issuer to access financing. But in a perverse way, rating agencies often help create debt problems. If rating agencies award higher-than-warranted ratings, companies or entire industries become tempted to take on more debt than they should.

Examples abound. Before the 2008 crisis, agencies gave high ratings to mortgage-backed securities and collateralized loans, and investors lost hundreds of billions of dollars. More recently, the debt of weak European governments was overrated based on the collective strength of the European Union (EU). Because of this, countries such as Greece were able to gain access to more debt than was sustainable. In the US, energy companies have been issuing lots of debt over the past six years to fund unconventional drilling, commonly known as fracking. We’ve written about this dynamic already.

Right now, debt issuance is surging in the consumer-products sector. The sector’s generally steady earnings result in generous ratings for these companies. However, anemic organic growth and pressure from shareholders have led management teams to issue debt to buy shares back (bad for bondholders) or to finance acquisitions (usually even worse for bondholders).

Why do credit agencies overrate? It’s easy to be optimistic about a company’s earnings and cash-flow prospects when business is strong. The most dangerous mistake any credit analyst can make is to extrapolate trends into the future. A better approach is to incorporate a range of possible outcomes, not fixed values, when predicting a company’s future performance. But agency analysts are generally tied to a formulaic methodology that doesn’t allow for this more dynamic assessment of credit risk.

And investment banks know how to push the limits. They’ll meet repeatedly with the agencies to tweak the structure of a deal. Their goal is to game the markets and achieve the rating they want for the cheapest possible debt. Plus there’s a conflict of interest: issuers pay for the ratings, which we suspect creates upward bias.

Bondholders lose big when optimistic assumptions don’t pan out. Ratings implicitly represent a series of assumptions—about economic growth, prices, demand, weather, politics, you name it. When a company has too much debt and one of these assumptions fails, it can lead to stress, ratings downgrades, defaults and losses for bondholders.

What were the inaccurate assumptions behind the rating of mortgage issuance? That aggregate US house prices hadn’t declined—and wouldn’t ever decline—materially, and that collateralized loans’ extremely low historical default rate wouldn’t change. With European bonds, many analysts assumed the EU would come to the rescue of troubled member countries before losses were forced on creditors. And with energy bonds, analysts mistook the relatively tight range on oil prices over the past five years as a guarantee that prices couldn’t fall.

Right now, the assumption for consumer products is that strong brand names built over decades will trump pricing pressures. We believe that trend is shifting.

Consumers today are increasingly price sensitive and digitally savvy—which makes branded consumer-staples companies more vulnerable. At the same time, startup competitors are taking advantage of low barriers to entry (food products can be made with a few simple ingredients) and the power of social media marketing to establish boutique brands in remarkably short time periods. Faced with these challenges, consumer-product companies are turning to acquisitions (note Heinz’s recently announced $46 billion takeover bid for Kraft).

The best defense (and offense) is to do your own credit work. The good news is that most investors are far less trusting today than they were seven years ago. All investors should know how to perform their own ratings analysis based on a hands-on assessment of fundamentals, and agency ratings should be just one of a number of inputs in any investment decision.

Ratings that are too rosy do have a silver lining, especially for active managers: they help create investment opportunities. The market’s overreliance on agency credit ratings sets the stage for disruptions to capital markets—and enables contrarian investors to buy bonds at yields that offer very attractive reward for the risk taken.

The views expressed herein do not constitute research, tax advice, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

Jeff Skoglund is Director of Credit Research at AllianceBernstein.

That's So Overrated: How Credit Ratings Do Damage