How Research from the High-Yield Market Can Enhance Equity Analysis

Martin S. Fridson, CFA CEO Fridson Investment Advisors New York City
Because equity analysts and high-yield analysts have different perspectives on valuation, insights from high-yield analysis can help equity analysts. In addition, the distinctive tools of high-yield bond analysis can reveal aspects of a companys operations not apparent to equity analysts. Two recent cases illustrate how the high-yield analyst works.

his topic of how high-yield research may be helpful in equity analysis is especially pertinent now because the year-to-date return on the Merrill Lynch High-Yield (HY) Master II Index currently stands at 53.36 percent, which I think would definitely qualify as an equity-like return. The last time the S&P 500 Index had a return of more than 50 percent was 1954, so even for stocks, the return of the HY Master II would signal a very good year. Do not count on this kind of high-yield performance for next year; mathematically, for returns to reach a similar level next year would be almost impossible. The returns of the HY Master II do show that even though bonds are viewed as terribly staid and possibly boring, coupon-clipping kinds of instruments, the bond market does have its moments of great excitement, particularly in the low-quality end of the market. The key points of this presentation are as follows: First, high-yield analysts have different perspectives on valuation from those of their equity counterparts. This does not mean high-yield analysis should be viewed as inherently superior to equity analysis; it is complementary. High-yield analysts look at things from a different angle, which can be useful. Second, the analysis of highyield securities has some distinctive features. Because high-yield analysts have a different perspective from equity analysts, they go through some steps that equity analysts might not automatically take. Some of these steps can be useful in evaluating stocks. Finally, some of the insights that high-yield analysts gain from their research of individual companies are important to both bond and stock investors. This presentation contains two case studies that illustrate this point.

Because the implications of the insights that high-yield analysts develop are important for analysis of stocks, the two types of analysis overlap. And high-yield analysts frequently become involved in stock evaluation. In the analysis of a company, an analyst may conclude that the preferred stock is the best way to participate in that company; sometimes, the common stock; and other times, convertible bonds. So, analysis of a company deals with a continuum of the various parts of the capital structure.

A Different Perspective
High-yield analysts pay close attention to what can go wrong. They are not enthralled with stories that suggest that the market is ignoring some important aspect of the companys business model that, once discovered, will lead to a much higher valuation for the stock. The main reason for this difference in perspective is that for high-yield bonds, and bonds in general, the price movement is skewed toward the downside. Figure 1 shows the price of the HY Master II over a 10-year period. New issues are typically priced at around a par value of 100, which represents a bond with a principal value of $1,000. Note in Figure 1 that the price of these high-yield bonds has never gone far above that par value but has gone far below it. The price was at an all-time low of 55 cents on the dollar late in 2008. The low points in previous bear markets were closer to 70 cents on the dollar, but this recent period has been extraordinary in many ways. In summary, as Figure 1 shows, the upside for a high-yield bond is limited. If an investor buys at the low points, that investor can make money on the upside. But in 20042007, most of the bond prices

This presentation comes from the 2009 Equity Research and Valuation conference held in New York City on 34 December 2009.

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Figure 1.
Price 110 100 90 80 70 60 50 99

Price of the HY Master II Index, 1 January 1999 through 30 September 2009

Par

00

01

02

03

04

05

06

07

08

09

Notes: Based on quarterly data. Price is shown as a percentage of par value. Source: Based on data from Bank of America Merrill Lynch Global Research.

were as high as they were going to go. Bonds may trade a little bit higher than par because, typically, when the bonds are newly issued, they are noncallable for the first five years. So, if interest rates go down or the credit quality of the company improves, the high-yield bond can attain a slight premium because the combination of the current income that it provides and the depreciation in the price of the bond over the next couple of years as the bond approaches its first call date will still provide a competitive return. Keep in mind that the bonds in this index are not convertible bonds. The index includes only straight, nonconvertible high-yield bonds, so these bonds will not trade at the $150$200 level. Because of the limited upside, the perspective of someone trading in these high-yield bonds must be different from the perspective of a trader in stocks, for whom there is no theoretical limit on how high a stock can go. The kind of phenomenal returns that can occur in stocks occur in high yield only if the bond is extremely depressed, and the risk is reflected in the purchase price. In aggregate, for the HY Master II as a whole (including those bonds in the index at depressed prices), the impact of price is a negative. Since inception of the HY Master II on 31 August 1986, 116 percent of the return for high-yield bonds has been the income. Contrast this situation with the income return for large-capitalization stocks: Dividends on large-cap stocks in that period supplied only 27

percent of the total return. Stock investors are seeking to make their returns through capital appreciation. For them, factors such as momentum, technical analysis, and so on, are significant. In comparison, high-yield investors are seeking to collect only their coupons. They want to buy bonds that will continue paying those coupons and avoid the bonds of companies that will default. One default on a bond purchased at par can wipe out a lot of income. Generally, the investor does have some warning of such a default. To be sure, bonds do not default when they are trading at par. They will be at fairly steep deep discounts long before they go to default. Someone, however, incurs that loss from the time of issue to the time of default. The second major difference between stock analysts and high-yield bond analysts is that to the highyield bond analyst, equity is a residual, just as the law states. Stockholders do own the company, but keep in mind that this ownership is contingent on the company doing what it is supposed to do for the creditorsnamely, pay them in full and on schedule. Stockholders can lose control and their rights can be removed if they fail to make good on the bondholders claims. From a legal standpoint, any money that goes to stockholders is a leftover. It is the residual after everyone else ahead of them has been paid. This is the perspective from which high-yield bond analysts do their analysis. This simple legal point is important, but it can easily be overlooked.

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Distinctive Features of High-Yield Analysis

In the bond market, analysts make some use of the Merton model, the model developed by Nobel Laureate Robert Merton: All the claims on the companywhether equity, debt, or some kind of hybridderive their value from the same set of cash flows. Therefore, the pricing of the companys stock must be consistent with the pricing of its bonds. Merton developed the idea that one could estimate the default risk of a company by looking at the level and volatility of the stock price. A lot of work was needed to move from that basic insight to a commercial product, but KMV, which is now owned by Moodys Investors Service, succeeded in developing a practical model, and others have developed additional variants. The basic insight is correct. The stock and bond prices cannot be out of line, although some realworld nuances have to be dealt with in getting to the relationship between the stock valuation and the bond valuation. The Merton model can be used in the bond world to conclude whether a bond is overvalued or undervalued. Its price should align with the stock price, and convergence should occur in the valuations of the stocks and bonds for the company. In keeping with this line of thought and the idea that equity is a residual value after everything else is taken care of, here is a description of how the highyield analyst would go about valuing a company. Table 1 shows key elements of the income statement for a hypothetical company. The top part shows the calculation of earnings before interest, taxes, depreciation, and amortization (EBITDA). All companies within an industry, regardless of their capital structure, should be on the same footing as far as the EBITDA measure is concerned. Some may have more debt than does the company in Table 1; some may have zero debt. On an EBITDA basis, however, and in terms of how private equity firms would look at them, the companies are all judged in the same way. In this example, for this industry, the peergroup multiple is six times EBITDA. The result is a total enterprise value of $5.1 billion. For high-yield analysts, interest coverage is very important (see the Memo line). They typically calculate it by using EBITDA rather than pretax income as the numerator. What this approach leaves outand analysts must be careful about it in valuationsis capital spending requirements. As the company grows, additions to working capital are required. So, looking at only the EBITDA coverage ratio can get one into trouble. For that reason, current approaches include analysis of free cash flow; that is, what does the company generate after taking care of its reinvestment needs?

Table 1.

Illustration of Equity Valuation by High-Yield Analysis (dollars in millions except share price)
$ 150 $ 280 $ 320 $ 100 $ 850 6.0 $5,100 Turns of Leverage () $1,275 $2,125 $1,700 $5,100 1.5 2.5 2.0 6.0

Projected income statement Net income + Income tax + Interest expense + Depreciation and amortization EBITDA Memo: EBITDA/Interest expense = 2.66 Peer-group multiple () Total enterprise value

High-yield analysis Senior secured loans Senior debentures Equity Total enterprise value

Equity value/net income = $1,700/150 = P/E of 11.3 Equity value/shares outstanding = $1,700/115 = Share price of $14.78

The bottom of Table 1 shows the waterfall of high-yield analysis, or in this case, the waterfall upside down. Ultimately, the analyst starts with that total enterprise value of $5.1 billion and deducts the claim of the senior secured lenders and then deducts the claim of the unsecured creditors and debentures. The far-right column shows a measure that high-yield analysts also use, the claims in terms of turns of leverage. This figure is the multiple of EBITDA that equates to the claim amount. (For example, for the senior secured claim of 1,275, dividing this amount by the 850 of EBITDA yields 1.5 turns of leverage.) A bondholder can look at those EBITDA multiples, consider how they may change, and determine whether his or her claims are still covered. From the data, it is also possible to determine the multiple of P/E, which is equal to the equity value of 1,700 divided by the net income of 150 for a multiple of 11.3 times. One can even calculate a share price. Also, although this point is not particularly important from the high-yield analysts standpoint, an analyst can take the equity value, divide it by the number of shares, and conclude that the stock should be worth $14.78 a share. The approach by the equity analyst is to start with the companys net income, take a P/E multiplenot of EBITDA but of earningsand then calculate an equity value from that analysis. Table 2 shows this approach for the example used in Table 1; in this case, the equity value comes to $2.1 billion. And again, simply dividing that number by the number of shares provides a share price of $18.26.

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Table 2.

Illustration of Equity Valuation by Equity Analysis (dollars in millions except share price)
$ 150 14 $2,100 115 $ 18.26

Net income Peer-group P/E multiple () Equity value Shares outstanding = Share price

Why the difference between the share prices found by the different approaches? The second approach does not differentiate between companies that are unlevered and those that may be highly levered. Of course, leverage does make a difference. The volatility of the income stream is sensitive to whether the company has financial leverage or not, and by rights, an analyst ought to assign a smaller multiple to the levered company. Without that step, by relying solely on the approach in Table 2, the analyst may wind up with a significantly higher valuation than when starting at the top, looking at the other claims, and seeing what is left over. Therefore, using the high-yield specialists approach is worthwhile as a check on the valuation derived from whatever model or approach the equity analyst is using. If the valuations are significantly different, the analyst will be alerted to the possibility that leverage is an issue and, therefore, the peer-group multiple applied to that particular stock is wrong. The reason lies with the consistency mentioned previously. The value of all the claims has to add up to the total enterprise value, and consistency is needed between the value of the equity and the value of the bonds. When an equity analyst comes at the study from a different perspective, the analyst may find stocks that are too highly priced or underpriced. Models like the KMV model look at this connection between the stock price and high-yield bond price on a snapshot basis. The model will tell the analyst that at a particular point in time, an inconsistency seems to arise, which may indicate that the risk is higher on the bond than is currently perceived. This kind of information is the main reason that bond analysts carry out this sort of analysis. Another way to look at the relationship between the stock price and high-yield bond price is over a period of time. Table 3 shows the changes in prices of a companys bond and its stock from one point to another in the last normal market period, early 2007. (Keep in mind that these data are not total returns.) Even if the prices of various securities of the same company moved in the same direction, they would unlikely move by the same amount. The reason is that equity, being at the bottom of the capital structure, reflects more leverage. In two

cases, the stock price moved less than the bond price, which is a bit anomalous because the greater leverage associated with the equity position should magnify its price movements relative to the bonds price movements. And also in two cases (shown in bold in the table), the bond and the stock price changes moved in opposite directions, which should not happen in a Merton-model world. If the total enterprise value of the company goes up, more value is left at the bottom for the stock, and the bondholder also has more of a cushion underneaththat is, more distance exists between the bondholder and a bankruptcyso the value of the bond ought to go up if the value of the stock goes up. Table 3. Price Changes on Randomly Selected B Rated Bonds and Related Stocks, 31 December 2006 to 31 March 2007 (price change in points)
Bond +1.75 0.63 +1.50 +0.75 0.25 +9.00 +0.69 +1.87 Stock 2.38 0.35 +4.94 1.73 0.41 +16.26

Company or Index Acco Brands 7-5/8% due 2015 Berry Petroleum Co. 8-1/4% due 2016 Dycom Industries 8-1/8% due 2015 General Communication 7-1/4% due 2014 Koppers Industries 9-7/8% due 2013 Novelis 7-1/4% due 2015 HY Master II S&P 500

Source: Based on data from Bank of America Merrill Lynch Global Research.

High-yield analysts are very conscious that the stock price might give them a signal. One reason is that some companies that are not followed widely on the bond side have extensive coverage on the equity side. Perhaps, by the same token, equity analysts could find value in keeping tabs on what is going on with the bonds of the companies they follow. Changes in bond prices might provide information about the stock, particularly if the prices move in opposite directions over an extended period. Such a situation ought to raise questions, especially if it was not caused by movements in the broader market. The bottom of Table 3 shows that both the stock market and the high-yield bond market were up in the period depicted.

Case Studies
The following case studies provide a bit more color to illustrate how high-yield analysis works out in practice and how analysis on the high-yield side may generate insights that are not apparent from a purely equity standpoint.

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Telecom/Media Sector in Mid-2002. The middle of 2002 was a very low point in the market following the disclosures of financial reporting irregularities at WorldCom. The loss of confidence was tremendous because the reporting for WorldCom and some other companies that came to light around the same time was so fraudulent and extremely difficult to detect from the financial statements. In many other cases, the financial ratios revealed at most that something was clearly not right. But at that time, some companies had off-balance-sheet transactions that effectively hid any problems with the integrity of the financial statements. So, confidence was low mid-year, and October 2002 was the low point for the high-yield market. The perception in the equity market was that the viability of the business models of the highly levered companies, particularly the former high fliers in the telecom and media sector, was questionable. A shake-out on the telecom side was expected and, indeed, did happen subsequently. The equity analysts perception of the situation was that these companies were all headed for bankruptcy, and as a result, buy recommendations for those companies were not to be seen. But a high-yield analyst who followed this sector looked at where the bonds were trading and concluded that equity investors ought to be considering them because the returns were likely to be equity-like over the next several months. The analyst did not think that these companies would go bankrupt because they were actually generating free cash flow after taking care of interest, capital expenditures, and working capital requirements. By being capable of generating cash, all of these companies would be financeable once the financing market reopened for them. The analysts conviction was that when the credit markets reopened, the companies would be able to roll over their existing debt and go on. And once the threat of bankruptcy as a result of not being able to refinance disappeared, the multiples assigned to EBITDA would expandnot because investors suddenly woke up with a different perception of the companies but because the risk factor would be greatly reduced. As a result, the prices of these bonds would be expected to improve dramatically. The analyst presented this argument to an equity manager. The response of the equity manager was, Well, if what you say is true, wont the stocks do even better? The high-yield analyst had to admit that the equity manager was right. Remember the waterfall analysis: If you add to the total enterprise value of the company, the biggest increase is at the bottom end. So, the telecom and

media stocks would go up more. It was a gutsy call, but that manager did go ahead and buy the stocks of a basket of companies that were very highly leveraged and very low rated. Table 4 shows what happened to a seven-bond basket and a seven-stock basket and the indices. Those high-yield bonds did have an equity-like return, certainly not what one normally expects to get from clipping coupons. Based on the returns shown, the total return on the bond basket was 92.11 percent and on the HY MasTable 4.
Basket/Index Bonds Seven-bond basket HY Master II Stocks Seven-stock basket S&P 500 140.63 1.55 82.64% 11.56

Bond and Stock Price Gains between 30 June 2002 and 30 June 2003
Gain

Note: Issuers in the baskets: Alamosa PCS Holdings, American Tower Corporation, Cablevision, Crown Castle, Nextel, SBA Communications, and Telus. Sources: Based on data from Bank of America Merrill Lynch Global Research and Standard & Poors.

ter II, 22.21 percent. Even the price gain of close to 12 percent for the HY Master II was exceptionally high for the high-yield asset class. The bonds of that group of seven companies, which were largely given up for dead by the equity investors, had a return of more than 80 percent. But just as that equity manager had suspected, the stocks did much better. Note that the stock market, as represented by the S&P 500, was down in this period. Clearly, the insight of the high-yield specialist was especially valuable in finding something that was going greatly counter to the overall trend in the market. The insights that made the difference in this case were simply understanding the role of financing and understanding the workings of the bond market. All the other facts were available for anyone. Adelphia in 2002. In May 2002, Adelphia Communications Corporation was flying high. On a scale of 1 to 5, with 1 a strong buy, the average rating for Adelphia stock was a buy at 1.9 (based on Thomson First Call information). It was not a strong buy, but the stock was being recommended by analysts. The company had just reported good earnings, and the stock was doing well.

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The company had a conference call related to that earnings report in May. While one high-yieldoriented hedge fund manager was asking a question, the stock started to fall. It fell 20 percent on the day, despite the report of good earnings. This turn of events caught the company by surprise; it was not the expected reaction to a good quarter. The ultimate outcome was that the company filed for bankruptcy a month later. Not only that, but the founder, John Rigas, and his son Tim were ultimately convicted of bank and securities fraud. They received, respectfully, 15-year and 20-year sentences. So, what was the question the hedge fund manager asked? What had he detected? The hedge fund manager was interested in the companys liquidity because liquidity is always an important issue in high-yield analysis. If a company is doing well but does not have cash or a way to come up with cash, it may run into serious problems. What the hedge fund manager had done was to track the purchases of stock by the controlling family. The family had a 35 percent stake and did not want to dilute its share. In contrast to some of the other cable companies that started out as family-controlled businesses and eventually got so big that the family members acknowledged they would have to reduce their ownership percentage, the Rigas family wanted to maintain its stake at 35 percent. Each time Adelphia made an acquisition that was financed partly by debt but also with a large issuance of stock, to avoid dissolution, the family had to buy 35 percent of each stock offering. The high-yield hedge fund manager had been tracking those offerings and figured out that the family was now on the hook for $1.5 billion. He knew the Rigas family did not have that much money, so

the question he asked was, Where were the family members getting the cash to make those purchases? Eventually, Adelphia made a disclosure in the financial statements that talked about a coborrowing arrangement. It came to light later that the family was using the borrowing power of the company itself to finance its stock purchases. This was simply a fraudulent use of the companys financial capability. The situation could have been detected only by someone who was concerned about liquidity issues. Before triggering the plunge in Adelphias stock price, the hedge fund manager had already become distrustful of the Rigas family. He had previously asked other questions, particularly concerning bond covenants, that management had clearly hoped would not be asked. He had become such a pest simply trying to get answers on behalf of investors that Adelphia senior managers stopped taking his calls. So, the borrowing was something he was inclined to be somewhat skeptical about.

Conclusion
In the case of Adelphia, equity analysis led to the conclusion that the stock was a buy. High-yield analysis led to the conclusion that the company was a fraud. Certainly, things do not always work out this way. High-yield analysts may miss things that equity analysts see. Insights will come out of the equity analysis that are valuable for the high-yield analyst just as insights come out of high-yield analysis that help the equity analyst. The key point is that looking at a company from more than one perspective can lead to immensely valuable insights.
This article qualifies for 0.5 CE credits.

R EFERENCES
Fridson, Martin, Kevin V. Covey, and Karen Sterling. 2008. Performance of Distressed Bonds. Journal of Portfolio Management, vol. 34, no. 3 (Spring):5662.

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Question and Answer Session

Martin S. Fridson, CFA
Question: What are the challenges of using option-based models in analyzing high-yield bonds? Fridson: These models have not been very useful. The models require some level of precision in the pricing to make them worthwhile. One of the aspects of highyield instruments is that the pricing for most issues is generally imprecise. In some cases, we have had to go back to the pricing service and point out that the bonds were trading at a point and a half higher than where the service had marked them at the end of the day. The high-yield market is not primarily an exchange-traded market. A system is now in place that shows the prices on a realtime basis, but the instruments are traded over the counter. The system is simply unlike the market for, say, large-cap stock, where continuous trading is occurring on the exchanges and where orders above and below affect the prices, so news that comes in is probably going to be cushioned fairly well. In these markets, the pricing is tight, so the option models can be applied there. Analysis is applied to the option to retire or not retire the bond after five years. The bonds typically are issued with a 10-year initial maturity, and retiring the bonds in the first 5 years is prohibited. After that, the company has an option to retire the debt, which is, of course, disadvantageous to the bondholder because the only time the company will call the bond is when it is trading above par. As a result, the upside for the bondholder is limited. The value of that option can be quite important in the price of the bond. So, good analytical methods are available for analyzing those options. Also, options-based models associated with high-yield bonds may suffer from added uncertainty. In the case of investmentgrade corporate bondsthose rated BBB or higher, which have a comparatively small risk of defaultthe option is fairly precise because the value of those options is almost entirely a function of interest rate volatility. The analyst can make some assumptions and use a model of volatility of interest rates to price that option. In the case of a high-yield bond, the call option is a function of interest rate volatility and credit quality. No one has come up with a perfect model to address that combination. The covenants also may be considered to be options, but they tend to be very particular to a specific bond. A good option model in this case plus a large database to test it are elusive because each covenant is crafted for each company. The Merton model is an application of option modeling using the volatility of the stock as a gauge of the default risk, so it has some application in this case. Question: Was the speculative emotion of the last couple of years in the stock market the same, higher, or lower in the high-yield market? Fridson: Generally lower because the market has less upside than the equity market. High-yield analysts dont get quite as enamored as equity analysts do with particular stocks or sectors. We are skeptical. Before Adelphia filed for bankruptcy, the stock kept coming back. New hope would spring up that the company would not file. On the last round, however, the bond market did not buy the story. The stock price had one last surge, but the bond market stayed flat. Then, the company filed. So, high-yield analysts dont get as enthusiastic as equity analysts do. Sometimes, of course, going along with the enthusiasm has value because, at least for a while, the stock may go up more than it deserves to. But I think going that route, following the bigger fool theory, has more of a penalty than does being skeptical, particularly because of the limit of liquidity. Question: Money follows performance, and the high-yield sector has been hot. Has the limited liquidity and high demand caused problems in actually managing the portfolios and capturing value in the high-yield market? Fridson: The spread between high-yield debt and U.S. Treasuries is still somewhat above average. The option-adjusted spread on the HY Master II is 740 bps. The historical average is more in the range of 550 bps. So, the market is not currently overvalued. In addition, there is some price upside because the default rate will probably come down somewhat over the next year. But liquidity is limited. A lot of the focus has been on the new-issue market. This has been a good time for companies to issue debt, particularly to refinance maturing debt in order to reduce the threat of becoming insolvent because all of the debt is coming due at the same time. Companies have largely resolved that problem for at least the next two to three years, but because of all the focus on new issues, the

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secondary market has been somewhat less active. Getting trades done in the secondary market is not easy. About 20 percent of the bonds, however, are still trading at distressed levels, meaning their yield spreads are greater than 1,000 bps over Treasuries. Some colleagues and I did a study recently that showed that the historical incidence of default on distressed issues is almost one in four, far above the average for all secondary market bonds (Fridson, Covey, and Sterling 2008). For the issues of less than 1,000 bps above Treasuries, the incidence of default is only a little over 1 percent per year. So, distressed bonds have risk, but the record says that three out of the four will not default. If the practitioner can figure out which are the ones that will not, he or she will probably make good money on those bonds. Much of the capital flow to the market has come in through mutual funds. Following the Lehman Brothers bankruptcy, the Reserve Prime Fund broke the buck; that is, the money market funds did not redeem shares at $1 per share. The Treasury then stepped in and provided insurance for the money market funds. At that point, $400 billion came into the money market funds money that would ordinarily have been in riskier assets but was more comfortable being in Treasurybacked, very short-term securities. That money then went back out. None of it went into stocks. It went into high-grade bonds, emerging market funds, and highyield funds.

Question: How has capital structure arbitrage held up during the global financial crisis? Fridson: Capital structure arbitrage has been an important factor in the high-yield market for the last decade or so. In fact, a certain amount of such arbitrage finding better values in subordinated debt than senior debt, or vice versahas always gone on. Preferred stocks also became involved in capital structure arbitrage as leveraged loans became traded instruments, which added another layer to the capital structure. Sometimes, investors use stocks as the short side of a twosided trade. That practice became popular around the beginning of the decade, particularly as the convertible arbitrage field got crowded. Some of those players evidently decided that a reasonably natural transition would be to move into the high-yield market. This sector did not have many longshort funds before the recent decade, but those funds have become more common. So, capital structure arbitrage is quite active. The spread per turn of leverage that I described is used in connection with the valuations for this arbitrage. Analysts look at where they are and how well they are covered and how much incremental spread they would get from moving to another level of debt as defined by the turns of leverage. Investors will see recommendations from the sell side that are premised on capital structure arbitrage, not based simply on long or short recommendations.

Question: Have the rating agencies done a good job? Are they obsolete? Fridson: They arent obsolete, but they are not a big factor on the speculative-grade side of the market. If a rating change moves a bond into a significantly different category, such as out of speculative grade altogether and into investment grade, that change will have some effect. But any step function change will probably have been anticipated. Analysts and investors in the high-yield market rely on their own work more than on ratings. No one in this market would say that they lost money because they relied on the ratings. As far as the ratings go, a sharp distinction must be made between the structured finance ratings and the more conventional corporate bond ratings. Little problem has occurred on the corporate side. With corporate bond ratings, the issue brought up is conflict of interest: The companies pay for the ratings, so how can they be reliable? But if a company has to raise money, it needs to have a rating. The company is paying for the rating, but the key point is that the company does not have much leverage to say whether the rating should be high or low. The problem with the structured finance products was that they were going to happen only if the top tranche was rated AAA. Without a AAA rating, structured finance deals were not going to occur. That conflict of interest was a much more difficult conflict to manage, and some of the criticism of that process is legitimate.

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