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AAA Ratings: Gold Standard or Fool's Gold?
Rating agencies are traffic cops for fixed-income markets. Their ubiquitous ratings heavily influence how investments are priced, and they've been rating bonds for 100+ years.
Historical 10-year default rates by rating grade:
AAA: 0.9%
AA: 2.3%
A: 2.9%
BBB: 7.3%
BB: 18.8%
B: 34.9%
---- AAA: The best of the best ----
How do rating agencies achieve 99%+ accuracy with their AAA ratings? By almost never assigning them.
e.g., there are only 2 AAA-rated companies: Microsoft and Johnson & Johnson.
Here's how rating agencies define AAA: "Extremely strong capacity to meet its financial commitments" (S&P.) "The lowest level of credit risk" (Moody's.) "Highest credit quality" with an "exceptional strong ability to meet financial commitments" (Fitch.)
---- Exception to the AAA rule: SASB CMBS? ----
Corporate AAA borrowers may make good on their debts 99%+ of the time, but 6 CMBS SASB pools have defaulted so far in 2024, generating $600M+ of losses on $1+ billion of loans. This 60% loss severity compared to 30-50% subordination buffers, means that AAA bondholders have taken losses.
Two of these SASB CMBS pools are outlined in this graphic: (i) a Blackstone-owned office building (the first acquisition made by Blackstone's core plus fund back in 2015, see link in comments for our earlier analysis on this) and (ii) a portfolio of San Francisco apartment buildings originated in 2021 and backed by Baupost.
---- Jekyll and Hyde ratings? ----
Securitized bond ratings are inherently out-of-the-box compared to their traditional corporate bond cousins, and SASB securitizations are even trickier because they lack the diversification of broader collateralization pools.
Nevertheless, rating agencies cram all those differences into their ratings. Usually they're right, but sometimes they're wrong. ...and when they are wrong, they're really wrong. e.g., CRE-CDOs.
There are at least two ways to explain this situation:
1. "Dear bond buyers: You get the point"
"AAA" just means relative best and isn't directly comparable across fixed-income types. Structured finance bonds are inherently different than corporate bonds.
2. "Dear rating agencies: WTF?"
How could you possibly miss by this much? Should you even be assigning any AAA-ratings to SASB pools? Something seems very broken.
Ps - 0.5% of outstanding SASB loans have defaulted in 2024. Not too bad in the overall scheme vs. traditional AAA default performance. ...unless more SASB defaults occur. SASB problem loan rates have leveled off, but nearly 4% are delinquent, 7% are in special servicing, and 37% are on watchlist.
Pps - "SASB" = single asset, single borrower; "CMBS" = commercial mortgage-backed securities; "CDO" = collateralized debt obligations
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