In this video, Multi‑Sector Income portfolio managers John Lloyd and Seth Meyer, discuss why credit ratings may not be an accurate reflection of risk and could obscure opportunities for active managers to capitalise on.

 Key takeaways

• Fundamental, bottom-up credit analysis provides opportunities to find companies that have improving credit quality, getting ahead of rating agencies that are often late to recognise credit improvement.
• Rating agencies rate the company, not the bonds. Because it is easier to forecast short-term risk than long-term risk, a lower rated short-dated bond could have less risk than a higher rated bond with a long maturity.
• Bank loan credit ratings are often capped by the parent company but a particular loan could have a structure that would allow it to be rated higher if it was a standalone company

 

Video transcript

John Lloyd: Hello, I am John Lloyd. I am Co-head of Global Credit Research as well as a portfolio manager on the Multi-Sector Income Strategy, and I am joined today with Seth Meyer, who is a portfolio manager on our high yield strategies as well as our Multi-Sector Income Fund. Today we’ll be discussing a topic for investors: to know what you own in your bond portfolios. As part of that topic, we are going to be discussing ratings and, do ratings accurately reflect the risks that are in portfolios?

Turning it over to Seth. The rating agencies will have an investment grade or a below investment grade rating and often people use that as a barometer of the riskiness of a particular bond or security. What is your opinion on the true reflection of the risk?

Seth Meyer: That is a great question, and it is actually the most difficult part about sub-investment grade investing. Rating agencies, generally speaking, do a pretty good job of appropriately allocating credit rating tags to individual companies. However, numerous inefficiencies exist, which is why I think an active manager can really exploit these ideas and inefficiencies within the market. It’s why you employ an entire credit research team to do bottom-up fundamental work and identify these stories that are really going through the process of moving up in credit quality.

Rating agencies will always be late in identifying credit quality improvement. If you can be first to understand when the credit quality improvement is happening, you generally are going to identify a great risk-adjusted return.

One further point of this is rating agencies also don’t delineate or discriminate between a one-year bond and a ten-year bond. So, what I mean by that is one of the things when you are buying a below investment grade bond, you are really being compensated for default risk.

It is significantly more difficult to forecast default risk over a ten-year period of time than it is over a one-year period of time. However, agencies don’t adjust for that. So, a CCC bond in the same capital structure that is ten-year in tenure (so, CCC [bond], ten years) versus a CCC bond that is one year; it is the same company — they are rated the same despite the fact that your ability to forecast the default is much more accurate over the next 12 months than it would be over the next 120.

Exploiting these inefficiencies is really one way to get above market yields but continue to dampen volatility. Finding those rising stars, those names that are going through the fundamental balance sheet transformational stories and then exploiting ideas within the individual capital structures, whether it be a ten-year bond or a one-year bond, are really ways to not just use rating agencies as a way to tell you whether or not it is a great risk-adjusted return; because I don’t think they do a good job there. However, they allow us as investors to go in and exploit these inefficiencies.

Lloyd: Yeah, I think another example is in the bank loan market, where a rating of an individual bank loan can actually be governed by its corporate family rating. I don’t think that is necessarily a great reflection of the risk of that particular security. You can actually have something that is very low leverage through the bank loan with a big cushion behind it.

What do I mean by cushion behind it? Well, maybe it has higher total debt, but then it also has the equity value behind it. So if it were to default and go into a bankruptcy, you’re multiple times covered on that bank loan; meaning you are going to get par back, you are going to get your interest and your principal back on that bank loan.

There are often times where you can see even a BB+ bank loan, which would be below investment grade — if it was a standalone security, it would look and have attributes sometimes better than a BBB rated bond. I think that is another way to exploit those spreads. In the market, they actually trade wider than BBBs do, [but] I think you are taking less credit risk and recovery risk in those types of examples.

Meyer: So these are two great examples of why you really need to understand what is in your plus bucket*, especially when you are investing in managers or portfolios that have below investment grade allocations. Ratings don’t dictate risk. They, generally speaking, do not equal each other. Exploiting these inefficiencies that we just discussed, I think, are ways to generate above market returns with less volatility.

Lloyd: Thank you for that, Seth.

 

 

*The part of portfolio invested in higher yielding sectors, aiming to generate a higher income.

 

In general, widening spreads indicate deteriorating credit worthiness of corporate borrowers, narrowing spreads are a sign of improving creditworthiness.