Voices: Morningstar now among largest players in credit rating market, and investors haven't noticed
Quick — name the world’s fourth-largest credit ratings company.
Most fixed-income investors can easily rattle off the so-called Big Three — S&P Global Ratings, Moody’s Investors Service and Fitch Ratings — which combined represented 95.8% of all outstanding U.S. ratings at the end of 2017, according to a SEC report. But after that, the remaining sliver of the market is something of a free-for-all, with firms like A.M. Best, DBRS, Kroll Bond Rating Agency and Morningstar Credit Ratings carving out niches where they can serve as alternatives to the top three.
But back to fourth place. Congratulations to those who knew DBRS, formerly known as the Dominion Bond Rating Service. The Toronto-based company, created in 1976 and acquired in 2014 by the Carlyle Group and Warburg Pincus, has a sizable footprint in Canada and, to a somewhat lesser extent, the European Union.
Apparently that mix was alluring to Morningstar, which in addition to equity research also issues debt ratings in the U.S., primarily on asset-backed and mortgage-backed securities. It announced on Wednesday that it had agreed to buy DBRS for $669 million in a transaction that’ll be financed with a mix of cash and debt.
All signs point to this being a smart acquisition. Adding DBRS and its annual revenue of about $167 million would have made Morningstar’s credit ratings business account for 17% of total revenue last year, instead of just 4%. The combination will create a more diversified ratings portfolio across regions and asset classes, with about 50% of the division’s revenue coming from Canada and Europe after the deal. Morningstar’s shares jumped 2.8% on Wednesday while the S&P 500 Index sank 0.7%.
“Together, DBRS and Morningstar can fulfill growing demand for differentiated fixed-income data, research, and analytics, a powerful secular trend that could serve as the backbone for change in the industry,” Kunal Kapoor, Morningstar’s CEO, said in a letter to the company’s stakeholders. “Despite increased calls for transparency since the financial crisis, we do not believe there has been adequate change to restore investor trust. Dominant competitors remain entrenched and fail to innovate on behalf of investors while delivering ratings in much the same manner as they had before the crisis.”
I understand that CEOs have to be excited about a new acquisition, and as I said before, it seems like a nice move by Morningstar at a company level. But let’s not get carried away. By and large, this move flew under the radar of many bond investors because DBRS and Morningstar combined have issued just 2.4% of outstanding credit ratings in the U.S. It’s not much better in the EU, where DBRS is the fourth-largest company despite having a paltry market share of 1.88%. If there really is pent-up demand for fixed-income research beyond what S&P, Moody’s and Fitch offer, it hasn’t materialized quite yet.
The truth is, there’s not much reason to expect the Big Three to lose significant market share anytime soon, if ever. They were caught flat-footed during the financial crisis when they awarded top grades to subprime mortgage investments, yet a decade later seem virtually unscathed. For many of the largest fixed-income markets, like standard corporate bonds or U.S. municipal debt, there’s little incentive for a borrower to switch over to a ratings company that’s less well known by individual investors.
As for institutional buyers, I can say with near certainty that they won’t be paving the way for new and improved credit ratings. After all, strategists and portfolio managers are paid to make their own independent evaluations of various securities. The fact that the Big Three may “fail to innovate on behalf of investors” is in some ways a feature, not a flaw, for these money managers as they look to beat their benchmarks. Understanding how S&P, Moody’s and Fitch react to certain events better than the competition is itself a tactical advantage.
Simply put, credit ratings aren’t exactly ripe for disruption. That doesn’t mean Morningstar can’t continue to chip away at the Big Three’s dominant market share, but its best bet is probably to stick to the asset classes that it and DBRS already do best. And make no mistake, the cutthroat environment among smaller companies is still very much in play. In March, Kroll took the unusual step of directly criticizing Morningstar’s grades on a commercial mortgage bond. Then this month, Fitch took an apparent swipe at rivals like Kroll for giving high ratings to risky bonds from online lenders.
For Morningstar to ultimately deliver on its goal of fostering wholesale industry change, it’s going to have to take things one percentage point at a time. At least for now, investors need not concern themselves with significant shifts in the credit ratings business. S&P, Moody’s and Fitch are as entrenched as ever.