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Bond Issues and Ratings

The Financial Times reported that a Church in Bradford displayed a large poster outside warning parishioners that, “despite inflation the wages of sin remain the same”. With quantative easing the question of when inflation will become a real problem and one difficult to eradicate remains unresolved. The answer to this question is vital when it comes to choosing between say the acquisition of a bond or the acquisition of equities.

WithInflation will eat away at the real return on a bond especially where the interest rate or coupon is fixed. However, in the same way that greed overcomes fear the drive for yield appears to overcome the fear of inflation. The result, new issues of bonds continue to be well received.

In particular Cambridge University recently issued a 40 year £350 million bond to investors. The bond was awarded a Moody’s triple AAA credit rating which set it apart from other academic institutions in terms of the quality of the investment proposition. Indeed this is anotch above the rating afforded to British Government bond issues or “gilts”.

The prospectus for this issue grappled with the precise nature of Cambridge University as an issuing entity. Is it in fact a legally distinct entity which can accept responsibility for repaying the principal and interest on the bond? Cambridge University is unique in being of a commonlaw corporation. There are no constitutional documents confirming the foundation of the University and the University was not established by Act of Parliament. In fact it only exists as a corporation because people treat it as such. As a result, the Cambridge University bond was actually issued by the, “Chancellor, Masters and Scholars of the University of Cambridge.”

So if in future a law student is asked to consider how many forms of corporate entity exist inthe UK, another needs to be added to the list, namely the common law corporation – it’s a corporation because we treat it as if it was.

On the theme of recent bond issues, the property company St Modwen Properties launched a retail bond with an annual interest rate of 6.25%. Unlike the Cambridge University bond there was no credit rating attached. The prospectus summary refers only to the fact that neither theissuer nor any of its subsidiaries have been assigned a credit rating.

This may be no bad thing bearing in mind the link between credit rating agencies and the overheating of credit markets leading up to 2008. To the surprise of many, rating agencies escaped the immediate flood of litigation which followed the collapse of Lehman Bros and the unravelling of sub-prime tapestries woven with AAA credit ratings. However, in an Australian Federal Court judgement this week, S&P was described as having “deceived” and “misled”buyers of a triple AAA rated complex derivative product created by ABN Amro. The investors in these products were all local Australian councils. In line with the heritage of the Dutchissuer these complex derivative products were called “Rembrandt” notes and were assigneda less than 1% chance of defaulting. Within six months there was a default and investors lostAU$16 million or 90% of the funds invested. The Judge in the case concluded that, “S&P’s rating of triple AAA for the Rembrandt 2006-2 and 2006-3 CPDO notes was misleadingand deceptive and involved the publication of information or statements false in materialparticulars and otherwise involved negligent mis representations to the class of potential investors in Australia.” The Judge continued, “ABNO Amro was knowingly concerned in S&P’s contraventions and the various statutory provisions proscribing such a misleading and deceptive conduct.”

Since the financial crisis began in 2008, credit rating agencies have avoided much of the blow-back. The reason, credit rating agencies argue they were only providing their opinion on the quality of the underlying investment. No reliance should be placed on those opinions by investors. In essence the rating agencies were not providing investment advice.

Whether the Australian case is a one-off or the tip of a litigation iceberg is unclear. Perhaps now the time has come for such products to be subject to a more rigorous disclosure regime.

This would involve on-line access to underlying title or charging documents so investors might know whose mortgage is covered by the product being sold. Until then investors would beunwise to follow as an investment maxim, “we believe the product is triple AAA rated andtherefore it is”. No doubt the wages of self-delusion remain the same.

This was posted in Bdaily's Members' News section by Tim Stocks .