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What does a AAA-rating really mean? A credit rating of ‘AAA’ has long symbolized the pinnacle of safety in the investment universe. In the past, many investors saw AAA and presumed that return of capital was certain. However, the recent financial crisis has shattered this perception and proved that some AAA-rated investments are not as secure as others. Typical AAA-rated investments include:
In the last three years, the AAA-rated securities in these five sectors had widely divergent experiences. The following chart shows the trailing 12-month returns of each sector (with indices1 chosen for similar interest rate sensitivities). This chart demonstrates how certain sectors were dramatically affected by the financial crisis in spite of their AAA-rating. CMBS and ABS were especially affected with 12-month losses in excess of 10%. The 2008 experience shows that there is a risk hierarchy within AAA-rated bonds, which is very important for investors who are seeking maximum protection for their assets. AAA-rated CMBS and ABS are the riskiest sectors and AAA Corporate bonds carry greater risk than AAA-rated Agency MBS. U.S. Government bonds have the least economic risk proven by their ability to generate greater (positive) returns during periods of economic stress. These results underscore the need for investors to look beyond the rating and determine sector preferences because losses in excess of 10% do not fit the risk profile of most AAA investors. Furthermore, this sector analysis does not reflect the true risk of investing in individual securities within the CMBS and ABS sectors. To examine individual securities, we analyzed three individual securities all of which are still rated AAA – one Commercial Mortgage-Backed Security, one Asset-Backed Security and one Corporate bond. Each is the most impaired from its issue price within its sector which has remained AAA-rated .
The graph shows that all three AAA-rated securities suffered losses during the financial crisis, particularly during the acute liquidity crisis following the collapse of Lehman Brothers. However, the Johnson & Johnson bond’s peak to trough loss was just over 10% whereas the CMBS and ABS securities both had losses of over 50%. Additionally, the Johnson & Johnson bond recovered its value a few months later, whereas the other two securities still have not fully recovered and may never recover as defaults prevent principal recovery. Clearly, while all three securities may be AAA-rated, their risk profile is quite different. To further this point, the following graph compares the AAA-rated CMBS and ABS with a lower-rated Corporate bond issued by Royal Bank of Scotland. RBS became distressed in 2008 and consequently the U.K. government made emergency infusions of capital to stabilize the bank in 2008 and 2009. This particular bond is subordinated and is currently rated BBB- by S&P.
Even with a BBB- rating, the RBS bond did not deteriorate as much as the AAA-rated CMBS and ABS securities during the financial crisis. Simply one cannot assume a ‘AAA’ rating is always synonymous with pristine credit quality. This is not to say that this experience is common for AAA-rated CMBS and ABS, as the economy has not experienced such a financial crisis since the Great Depression. However, this experience proves that investors who are seeking maximum security cannot merely buy the rating and rely on AAA to protect them. AAA simply does not have the same meaning across sectors so investors must examine each security to determine whether it has the risk, return, structure and liquidity characteristics which will meet their portfolio’s investment objectives.
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