Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 134

Lessons from the Volkswagen scandal

The revelation that Volkswagen (VW) has been systematically defrauding environmental regulators (and thus customers) across the world has two main lessons for credit investors. While neither of these lessons is new, this is a timely reminder of both.

1. Companies are not run for the benefit of bondholders

In most jurisdictions, company directors are not required to act in the best interest of creditors unless the firm is insolvent. In VW’s case, whether this fraud was known at board level or not, it is clear that a culture existed that focused on profit first and foremost i.e. making the shareholders, and likely management of the firm, rich. While the agency issues of management versus shareholders are well documented, the impact on bondholders of this type of activity is less understood.

Presumably the motivation for their activity stemmed from the cost savings, and hence increased profits, of rigging the emissions testing compared to building the cars, with the same power and fuel economy, that actually complied with the standards. Assuming that this was a deliberate corporate strategy to defraud regulators, there could be one of two possible outcomes for the firm. Below we consider the return profiles for both equity and bondholders in these outcomes, acknowledging that there is always an unknown, but non-zero, probability of being discovered.

Possible outcome 1: they continue to get away with it, thus profits are boosted and shareholders win. Dividends and share prices would continue to rise and hence the owners benefit from the reward of taking the risk (of getting caught).

Possible outcome 2: they get caught and they face large fines, restitution costs, brand damage and possible longer term viability issues for their firm. Clearly here, equity holders have borne the cost of the losing bet.

Now look at this from the perspective of bondholders. Outcome 2 clearly impacts bondholders negatively. The value of the company’s bonds falls (as credit spreads widen), their credit ratings are downgraded, and bondholders too, face the heightened probability of future distress for the firm.

But what about outcome 1 – do bondholders win or lose? Clearly the benefits of increased profits go completely to shareholders – so bondholders do not win as a result of not getting caught. But further, to the extent that the firm looks to be more profitable than it really is, this will, all other things being equal, result in credit analysts assessing the firm to have a lower default probability than it really does. The implication is that bondholders actually lend to this company at a lower rate than they otherwise should. Hence bondholders are not being appropriately compensated for the true risk they are exposed to and in turn receive lower returns.

While equity holders face a symmetric outcome, winning under outcome 1 and losing under outcome 2, bondholders lose under both!

This example highlights the need for investors to, as fully as they can, incorporate environmental, social and governance (ESG) risk assessments in their credit process. Directors at VW either created a culture where the imperative to achieve performance targets overrode any requirement to remain within the law, or they were blind to the weaknesses in their own governance framework. Companies who control these risks poorly will often manage other risks poorly, resulting in significant financial impacts on the firm. Whilst such analysis will not always uncover these risks (as is clearly the case with VW), the risks are real and can rapidly convert into financial risks.

2. Diversification is the ultimate protection against shocks

Recent high profile corporate scandals, such as the BP oil spill in 2010, have been accompanied by commentary and analysis around whether it would have been possible for a credit analyst who ‘knew the company’ to have identified, ex-ante, the issues around this company. While no analyst would ever have predicted the Gulf of Mexico disaster, it is possible to argue that some of the risk factors were more visible in the VW case.

While VW had some visible governance issues around it – a single shareholder block holds 90% of the voting shares, non-independent majority on the board, no fully independent audit committee nor independent remuneration committee – these are not all that unusual in many bond issuers. Despite these issues, it would be highly unlikely that any credit analyst, who really dug deep into and ‘knew’ VW, would have identified that the firm was undertaking such a widespread fraud on its customers.

Such an unexpected outcome, especially given the asymmetric return profile explained above, clearly argues against credit approaches that rely on ‘really knowing a company’ and holding large concentrations in them.

In debt, concentration is an unrewarded risk. The best way of managing credit portfolios, where outcomes like the VW case can, and do, happen is to build highly diversified portfolios.

To summarise:

  • Shock events like the VW emissions scandal are almost impossible to predict. Even the best analysts are unlikely to ‘know’ a company well enough to uncover this level of fraud.
  • Likewise, the best ESG processes would not have discovered the ‘diesel dupe’, but rather are more likely to pick up governance issues supporting a culture for unlawful practice.
  • Bondholders will lose in these scenarios as companies are run to benefit shareholders, not bondholders.
  • The best way to limit the impact from these shocks in a corporate bond portfolio is to diversify. Hold a little of a lot so that losses due to a big event / default are limited, minimising the impact to your overall return.

 

Tony Adams is the Head of Global Fixed Income and Credit for Colonial First State Global Asset Management. This article is for information purposes only and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Now you can earn 5% on bonds but stay with quality

The ‘low versus no’ risk appetite for internal fraud

Managing credit risk requires healthy dose of cynicism

banner

Most viewed in recent weeks

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

What to expect from the Australian property market in 2025

The housing market was subdued in 2024, and pessimism abounds as we start the new year. 2025 is likely to be a tale of two halves, with interest rate cuts fuelling a resurgence in buyer demand in the second half of the year.

Howard Marks warns of market froth

The renowned investor has penned his first investor letter for 2025 and it’s a ripper. He runs through what bubbles are, which ones he’s experienced, and whether today’s markets qualify as the third major bubble of this century.

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

The 20 most popular articles of 2024

Check out the most-read Firstlinks articles from 2024. From '16 ASX stocks to buy and hold forever', to 'The best strategy to build income for life', and 'Where baby boomer wealth will end up', there's something for all.

Latest Updates

Shares

Howard Marks warns of market froth

The renowned investor has penned his first investor letter for 2025 and it’s a ripper. He runs through what bubbles are, which ones he’s experienced, and whether today’s markets qualify as the third major bubble of this century.

Property

What to expect from the Australian property market in 2025

The housing market was subdued in 2024, and pessimism abounds as we start the new year. 2025 is likely to be a tale of two halves, with interest rate cuts fuelling a resurgence in buyer demand in the second half of the year.

Superannuation

How to fix the Commonwealth Superannuation Scheme

The scheme has not been updated since it was established and is no longer fit for purpose. Members now find themselves disadvantaged in several important ways versus those in other superannuation funds.

Investment strategies

5 key investment themes for the next decade

AI has helped markets to new highs and rightly dominated news headlines. Yet there are other themes, including niche ones such as gene editing, which are also expected to drive investment returns over the next decade.

Shares

New avenues of growth make 2025 exciting for investors

Investors need to be more discerning this year as headline valuations are high and the economic cycle turns. Dig a little deeper, though, and there are big opportunities in overlooked shares with strong tailwinds.

Investment strategies

The pros and cons of debt recycling strategies

Debt recycling is a powerful strategy for those juggling the seemingly competing goals of debt reduction and building an investment portfolio. Yet it's often misunderstood because it isn't just a single strategy.

Investment strategies

Australia is out of step on nuclear power

Globally, nuclear power is gathering momentum as a differentiated power source in the energy transition to zero carbon emissions. Yet in Australia, a nuclear ban remains, making us an outlier among our Western Allies.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.