There was a relatively brief period, in the depths of the global financial crisis, when the reliability of credit ratings – those apparently simple, shorthand codes representing a credit rating agency’s assessment of the risk of lending to a corporate, government or quasi-government borrower – was repeatedly called into question.
In subsequent years, and even through the coronavirus pandemic, the topic has been less of a feature of the mainstream news agenda. While this may come as something of a relief to those who do not spend a significant proportion of their waking hours conducting fundamental research on corporate bond issuers, we believe this is an aspect of fixed income investing that is now worthy of closer examination. Under current market conditions, we would argue that investors would be wise to focus their attention on the relative risk/return opportunities presented by the lower end of the investment-grade spectrum of ratings, namely those issuers rated A or BBB.
While the perceived risk around BBB continues to surface periodically in commentary – usually highlighting the growing proportion of the investment grade market that those bonds represent or the downgrade risk into high yield territory and the underperformance that would follow for those affected instruments – we observe less attention is being paid to the relative risk/return attributes of A-rated bonds.
We find this interesting as, from our perspective, A-rated bonds (in aggregate) currently offer the least compelling investment case in investment grade corporate credit. Our currently negative view is based on the very low credit spreads on offer to own A-rated bonds (currently the lowest since the financial crisis), compared and contrasted with the underlying quality of the issuers and the history of spread volatility in less benign market conditions than those prevailing today.
What’s in a few letters, between friends?
At the root of our contention is a belief that, to fully understand the risk and return characteristics of different issuers in this part of the rating spectrum, there is no shortcut that averts the need for detailed in-house credit analysis, and that excessive reliance on third party credit ratings to drive expectations of risk and return poses hazards. We do not criticise the rating agencies – they are doing their job professionally and within prescribed methodologies. But as investors, we also need to formulate our own views of credit risks to issuers and, equally importantly, to determine the appropriate level of credit spread that compensates for those risks.
For example, let us reflect on the fact that numerous regulated utility businesses are rated triple-B, while many financials (including banks and insurers) as well as issuers in other cyclical sectors such as commercial property and autos are rated single-A.
Credit spreads on A-rated financials versus BBB-rated utilities in the era of Covid
Source: Bloomberg, as at 3/6/21
On paper, the A-rated issuers should have lower credit risk than their BBB-rated peers and should offer lower volatility through the market cycle. After all, surely the relative risk is captured in the “alphabetical advantage” of their superior credit rating.
In the real world of the corporate bond market though, such assumptions and simplifications are unlikely to stand up to detailed scrutiny. When market conditions are volatile and investors are nervous, complacency based on credit ratings falls away and the fundamental attributes of businesses and sectors become all-important in determining the performance of their bonds. History demonstrates that BBB-rated non-cyclicals can readily outperform A-rated cyclicals and financials in a down-market, despite their “inferior” credit ratings.
From the starting point of today’s euphoric market conditions, with credit spreads at post financial crisis lows, we believe that alpha generation is increasingly dependent on diligent bond-by-bond analysis to ensure that the credit spreads on offer adequately compensate for the underlying quality of issuers (and volatility of investor sentiment towards them through the business cycle). External credit ratings can help to inform, but should not determine, that analysis.
BBB-ware the BBB-vangelists
It is important to emphasise that we are not evangelists for BBB-rated bonds; we are, in fact, underweight BBB relative to the broad market. Given that this rating bucket encompasses a broad universe of different sectors, issuers, and credit qualities, naturally its constituents require a detailed fundamental assessment on a case-by-case basis. Our emphasis is simply that the same framework and discipline must be applied to A rated credit, which – after all – may only be one notch higher rated than many BBB bonds. In the portfolio, we are running a significant underweight to A-rated bonds as well, precisely because our credit methodology suggests to us that current spreads for many of the issuers in that rating category do not adequately compensate for the volatility we would expect if market conditions started to sour somewhat. While BBB’s closer proximity to junk risk will always attract attention and headlines, its A-rated cousin has similar potential to hurt performance if investors find themselves overly long the wrong bonds at the wrong credit spreads.
Take for example the sell-off in the sterling corporate bond market witnessed during March 2020, in the early stages of the Covid-19 panic; while both A-rated and BBB-rated issues saw spread widening, it could be argued that BBB in fact outperformed on a relative basis. From February to March 2020, the spreads of GBP A-rated bonds at an aggregate level widened to 150% of their pre-covid levels (from 102 to 255 basis points), while the spreads of GBP BBB-rated bonds only widened to 126% of their pre-covid levels (from 146 to 330 basis points). In absolute terms, BBB bonds only widened 31 bps more than A rated bonds during the sell-off. In such circumstances, taking a broad view of A-rated issuers as being significantly more defensive in nature than BBB and/or offering a superior risk/return profile on a blanket basis looks distinctly problematic.
With the potential for future spread widening if/when the current market narrative shifts, the importance of understanding issuer-specific risks has arguably never been greater. Our mantra in this regard is to “question everything,” and to refuse to be pushed into accepting an inherently imprecise market narrative. We intend to stick to it.
The value of Active Minds