Tuesday, July 13, 2010

Whys is AAA not a coveted prize any more ?

Hold your breath, all ye men and women – there are now only four companies in the world which are AAA rated – ADP, Johnson & Johnson, Microsoft and ExxonMobil. That’s it. Why are there so few in this exalted list ?

Before I go further, this is not a “technical” blog. Technically I should be saying companies whose bonds are rated AAA . Short term or long term ? Moody’s or S&P or Fitch ? Is Moody’s rating not Aaa ? Let it go. It doesn’t matter. The point is not to be technically correct. A AAA rating (in whatever form) acknowledges that the company’s bonds (not shares) have the highest degree of safety . Wouldn’t it be something every company would die for ? Obviously not. Only four companies are there. Why so few ?

The recent financial crisis has taken its toll. Quite a few have dropped off the list in the last couple of years. Notably GE, a long time star of that list. Understandable. But this doesn’t explain the paltry list fully.

Some companies deliberately get off the list for strategic reasons. A good recent example is Pfizer. Pfizer decided on a big strategic acquisition in Wyeth. It took a lot of debt on its balance sheet to do the deal. It lost its AAA rating because of this deal, but was perfectly happy to do so. Many companies decide to forgo their AAA rating for a strategic acquisition.

The real issue is the cost versus benefit of maintaining a AAA rating. Bragging rights is all fine, but bragging has little economic value. The real value of a AAA rating is that your cost of borrowing is lower. But to achieve that, you need to meet a number of stringent parameters, including having very little debt on your balance sheet (every one of the four on the list has virtually no debt). Perversely, as a company, if you have all equity and no debt, your cost of capital is high. So what’s the use of lower borrowing costs if you are not borrowing in the first place, or borrowing very little ? Companies decide that the AAA rating is simply not worth the price and therefore don’t aspire for it.

Rating agencies have also become very wary of AAA ratings. Quite a few members on that list have subsequently defaulted !! AIG, once a member of that club, is a good example.

But somehow, it doesn’t seem right that only four companies in the world have the highest degree of financial safety. Is the corporate sector simply too risky ? Or has risk not been priced properly enough to warrant some more companies deciding that the trade off of cost of borrowing and stringency of safety requirements is worth it ? Or does the investment market simply not care for the “highest” degree of safety and is perfectly happy with “adequate” levels of safety ?

So what does the “Scottish widow” (euphemism for the most risk averse investor) do with her money ? Dig a hole in the backyard. Hardly safe. Buy gold ? You must be joking. Put it in a bank ? This is what most widows do, but show me a AAA rated bank. There is just the mistaken belief that there is an implicit sovereign guarantee and that no country will allow a bank to go bust.

I can understand all the logical reasons why there are so few companies at the top, but somehow it seems odd that only four companies in the world are really really really safe financially.