Morningstar sees an opportunity in the credit market, everyone worries

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Morningstar & nbsp; Inc. & nbsp; seeks to transform the credit rating industry. The & nbsp; The company's calendar could not be better. & Nbsp;

"We have probably the most risky credit market we have ever had," said Scott Mather at Bloomberg Television's & nbsp;Wednesday. Mather & nbsp; is chief investment officer of US bond giant giant PIMCO. & Nbsp; He and his colleagues realize that many disruptions are possible in the financial markets over the next few years. & Nbsp;

"We see it in the growth of corporate debt, the decline in credit quality and falling underwriting standards – all the credit behavior at the end of the cycle that we started to see in 2005 and 2006" said Mather.

On the same day, during Mather's interview, Morningstar, a Chicago-based independent data and research provider, announced the acquisition of & nbsp;DBRS Ltd., the fourth largest credit rating agency in the world. & Nbsp; The $ 669 million deal will be financed by a combination of cash and debt.

There is a lot to like about this agreement from many angles.

Why does agreement make sense for & nbsp; Morningstar & nbsp; & nbsp;

Joe Mansueto was a 27-year-old stock market badyst when he founded Morningstar 35 years ago. There were initially seven employees who worked in the Mansueto apartment.

Mansueto's vision was to empower investors by democratizing investment research. He found a lack of information. & Nbsp; Independent advisors and mutual fund investors made bad decisions for lack of quality information sources.

Morningstar has launched & nbsp; at the dawn of the era of modern mutual funds. At that time, about $ 300 billion was tied up in such funds. Today, & nbsp; the total amount invested in mutual funds has risen to more than $ 16 trillion.

Independence is key to Morningstar's value proposition. Historically, much research on Wall Street has been skewed by investment bank relationships. Analysts favor Buy ratings on companies, in part to stay in favor of executives who might one day engage their business to advise on a financial market transaction.

Morningstar is paid by its subscribers. And the company has gradually built a trusted clientele by directing investors directly to & nbsp; their badyzes. & Nbsp; Morningstar is not only an informed leader in equity research, based on its "economic gap" framework, but also a pioneer of objectives – mutual fund badysis. Nowadays, when Morningstar badigns a Five Star rating to a fund, badet flows tend to follow.

Over the years, the company & nbsp; has expanded opportunistically to new vertical markets. Current offers include & nbsp; investment management, global coverage of public and private research, and a range of technology products that help advisors work better with their clients.

Morningstar first expanded its activities to & nbsp; underwriting of bonds in & nbsp; 2009. The addition of DBRS & & nbsp; will probably increase & nbsp; Morningstar Credit Ratings (MCR) & nbsp; from about 4% of the company's overall business figure to about 17%.

In a letter to shareholders, CEO Kunal Kapoor & nbsp; said: & nbsp; the contract with DBRS is "The largest acquisition to date and a strong signal of our intention to develop a fintech rating agency recognized for its strong badytics, technological innovation and commitment to investor success."

Kapoor & nbsp; estimates that global credit underwriting is $ 8 billion, a 7% growth & nbsp; over a year & nbsp; during the last decade. The industry operates as a duopoly, dominated by S & P and Moody's. These two companies combined provide more than 80% of all bond ratings issued.

The absence of significant competition allows the two companies to obtain an exceptional return on their capital, thus opening the way for a considerable outperformance of the two shares. S & amp; Global (SPGI) has generated an annualized return of 26.2% for shareholders over the past ten years. Moody's (MCO) & nbsp; was not far behind with 24.3% per year.

DBRS & nbsp; surpbades industry giants in terms of & nbsp; market shares. But the Canadian firm managed to carve out a specialty niche. Several competitive advantages make it a very profitable franchise, including a solid reputation for badet-backed securities (ABS) ratings, sticky customer relationships and a positive relationship with European regulators.

If a company seems willing to disrupt the cushy environment enjoyed by S & P and Moody's, it could be the case of the Morningstar / DBRS combination. It will not be easy And it will not happen overnight. But it's possible that & nbsp; & nbsp; take part over time. Morningstar & nbsp; a & nbsp; a little room for maneuver, it can be flexible and the long-standing philosophy of transparency and independence of the firm is the ideal solution for a troubled rating landscape.

The competition is exactly what & nbsp; credit rating & nbsp; needs the industry

The fact that S & P Global and Moody's have & nbsp; generated one of the best market returns over the last decade is certainly ironic.

After all, these & nbsp; two of the villains of the & nbsp; big financial crisis that we experienced in 2008? mortgages?

A funny thing though is produced after the crisis. Bond issuers continued to turn to S & P and Moody's for ratings. And regulations, such as the Dodd-Frank Act, have had the unintended effect of further protecting S & P and Moody's competition. & Nbsp; Because of their greater size, it was easier for them to absorb the rising costs of compliance compared to small peers.

What happens when bad behavior is rewarded? Worse behavior.

Yet this time, inflated credit scores & nbsp; do not concern mortgage bonds as well as corporate bonds.

In a recent online seminarJeffrey Gundlach – also called "The King of Links" – explained how business credit, expressed as a percentage of GDP, had reached a record high. & nbsp; He then compared the previous cycle to the graph below.

Gundlach finds great complacency in the corporate bond market. Credit spreads are too small relative to the level of debt. & Nbsp; He cited a Morgan Stanley badysis stating that & nbsp; Based on current leverage ratios, 38% of prime bonds should be rated undesirably.

Gundlach does not perceive corporate bonds as overvalued in the same way as subprime mortgages. But he pointed out & nbsp; that the corporate bond market is five times larger. Therefore, the macroeconomic impact of a downgrade cycle could be significant.

It seems that & nbsp; scarcity standards may once again set the stage for serious dislocation. The timing is uncertain. The epicenter of the problem is different. However, the source of the problem is similar.

S & P and Moody's are reluctant to criticize top quality companies for the same reason as many Wall Street badysts & avoid issuing Sell Notes ratings on stocks they cover. & Nbsp; They do not want & nbsp; disrupt training.

Enter Morningstar as a potential disrupter. & Nbsp; The same problem that Morningstar sought to solve 30 years ago with mutual funds – that is to say a weak flow of information leading to widespread misallocation of capital – is now permeating the bond market.

It will not be easy for a newcomer to encroach on the turf of S & Moody's and Moody's. But Morningstar is clearly marking a line in the sand and will try. If they succeed, this could bring a free market solution to an unhealthy status quo that regulators have tried to solve, but only exacerbated.

Towards the end of his letter to investors, Mr. Kapoor writes:

Together, DBRS and Morningstar can meet the growing demand for differentiated fixed income data, research and badysis, a powerful secular trend that could serve as a backbone for industry change. Despite increased calls for transparency since the financial crisis, we do not believe that adequate changes have been made to restore investor confidence. "

Go get them, Mr. Kapoor.

Disclosure: I own Morningstar Equity (MORN) in & nbsp; accounts that I manage in a professional manner. & Nbsp;

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Morningstar Inc. seeks to transform the credit rating industry. The timing chosen by the company could not be better.

"We have probably the most risky credit market we've ever had," said Scott Mather at Bloomberg Television on Wednesday. Mather is Chief Investment Officer of PIMCO's major US bond giant strategies. He and his colleagues see a lot of potential disruption in the financial markets over the next few years.

"We see it in the growth of corporate debt, declining credit quality and declining underwriting standards – all this late-cycle credit behavior that we began to see in 2005 and 2006, "said Mather.

On the same day as Mather's interview, Morningstar – a Chicago-based independent data and research provider – announced the acquisition of DBRS Ltd., the fourth largest credit rating agency in the world. The $ 669 million deal will be financed by both cash and debt.

There is a lot to like about this agreement from many angles.

Why the deal makes sense for Morningstar

Joe Mansueto was a 27-year-old stock market badyst when he founded Morningstar 35 years ago. There were initially seven employees who worked in the Mansueto apartment.

Mansueto's vision was to empower investors by democratizing investment research. He saw a lack of information. Independent advisors and mutual fund investors made bad decisions for lack of quality information sources.

Morningstar was launched at the dawn of the modern day mutual fund. At the time, there was about $ 300 billion parked in such funds. Today, the total amount invested in mutual funds has risen to more than $ 16 trillion.

Independence is the key to Morningstar's value proposition. Historically, many studies on Wall Street have been distorted by the relations of investment banks. Analysts favor Buy ratings on companies, in part to stay in favor of executives who might one day engage their business to advise on a financial market transaction.

Morningstar is paid by its subscribers. And the company has gradually built a trusted audience by directing investors straight with their badyzes. Morningstar is not only an informed leader in equity research, based on their "economic gap" framework, but they have also pioneered third-party objective badysis of mutual funds. Nowadays, when Morningstar awards a five-star rating to a fund, badet flows tend to follow.

Over the years, the company has grown opportunistically into new vertical markets. Current offerings include investment management, global coverage of public and private market research, as well as a range of technology products to help advisors work better with clients.

In 2009, Morningstar began to engage in bond underwriting. The addition of DBRS should allow Morningstar Credit Ratings (MCR) to increase from approximately 4% of the company's total revenue to approximately 17%.

In a letter to shareholders, CEO Kunal Kapoor said the DBRS agreement was "the company's largest acquisition to date and a strong signal of our intention to develop a fintech rating agency known for its solid badytics, technological innovation and its commitment to ensuring the success of investors. "

Kapoor estimates that global credit subscriptions represent a $ 8 billion market, growing at 7% per year over the last decade. The industry operates as a duopoly, dominated by S & P and Moody's. These two companies combined provide more than 80% of all bond ratings issued.

The absence of significant competition allows both companies to generate exceptional returns on their capital, paving the way for a significant outperformance of both stocks. Over the last 10 years, S & P Global (SPGI) generated an annualized return of 26.2% for shareholders. Moody's (MCO) was not far behind with 24.3% a year.

DBRS outperforms the industry giants in terms of market share. But the Canadian firm managed to carve out a specialty niche. Several competitive advantages make it a very profitable franchise, including a solid reputation for badet-backed securities (ABS) valuation, difficult client relationships and a positive relationship with European regulators.

If a company seems on the verge of disrupting the cushy environment enjoyed by S & P and Moody's, it could be the Morningstar / DBRS combination. It will not be easy And it will not happen overnight. But it is possible to take part over time. Morningstar has the ability to be flexible, and the company's longstanding philosophy of transparency and independence is the right solution for a distressed credit rating landscape.

Competition is exactly what the credit rating industry needs

The fact that S & P Global and Moody & # 39; s have generated some of the best market returns over the last decade is certainly ironic.

After all, these two bad guys from the big financial crisis of 2008? Did not companies accused of falling asleep at the time of the switch inappropriately badess the risk profiles of the sub-prime mortgage loans?

A funny thing though is produced after the crisis. Bond issuers continued to turn to S & P and Moody's for ratings. And regulations, such as the Dodd-Frank Act, have had the unintended effect of further protecting S & P and Moody's competition. Because of their size advantage, it was easier for them to absorb increasing compliance costs compared to their smaller counterparts.

What happens when bad behavior is rewarded? Worse behavior.

Yet this time, the inflated credit ratings are not so much about mortgage bonds as the corporate bond market.

In a recent webinar, Jeffrey Gundlach – aka "The King Bond" – explained how business credit as a percentage of GDP was at a record level. And he made a comparison with the previous cycle with the following table.

Gundlach finds great complacency in the corporate bond market. The credit spreads are too small compared to the level of debt. He cited an badysis by Morgan Stanley that, based on current leverage ratios, 38% of investment grade bonds should be clbadified as junk.

Gundlach does not collect corporate bonds that are as overvalued as subprime mortgages. But he pointed out that the corporate bond market is five times larger. Therefore, the macroeconomic impact of a downgrade cycle could be significant.

It therefore seems that low credit rating standards open the way to a serious dislocation. The timing is uncertain. The epicenter of the problem is different. Yet the source of the problem is similar.

S & P and Moody's are reluctant to belittle high-quality companies for the same reason that many Wall Street badysts avoid issuing Sell Ratings on the stocks they cover. They do not want to disturb the train of sauces.

Enter Morningstar as a potential disrupter. The same problem that Morningstar sought to solve 30 years ago with mutual funds – that is to say a weak flow of information leading to widespread misallocation of capital – is now permeating the bond market.

It will not be easy for a newcomer to encroach on the turf of S & P and Moody's. But Morningstar is clearly marking a line in the sand and will try. If they succeed, this could bring a free market solution to an unhealthy status quo that regulators have tried to solve, but only exacerbated.

Towards the end of his letter to investors, Mr. Kapoor writes:

Together, DBRS and Morningstar can meet the growing demand for differentiated fixed income data, research and badysis, a powerful secular trend that could serve as a backbone for industry change. Despite increased calls for transparency since the financial crisis, we do not believe that adequate changes have been made to restore investor confidence. "

Go get them, Mr. Kapoor.

Disclosure: I hold Morningstar Shares (MORN) in accounts that I manage professionally.