Overview

Today’s lesson will focus on credit ratings and how to utilize them in order to manage your portfolio and potentially select strategies that will enhance returns.

Credit Rating Definitions

There are generally two credit rating agencies that investors pay attention to: Standard & Poor’s and Moody’s. Credit rating categories range (in the case of S&P) from AAA (highest rating) to D (lowest rating). See below for each company’s credit categories and corresponding definitions:

1. Moody’s
2. S&P

One important consideration is the separation of “investment grade” and “high yield” bonds. Investment grade bonds (categorized typically as AAA through BBB rated bonds using the S&P categories and Aaa through Baa3 using the Moody’s categories) are generally “safer” investments than high yield bonds. More risk, in the case of bonds, refers to the increased probability of default. Given this perspective, a few key differences exit between the two:

1. Investors will demand a higher expected return high yields to make up for the additional risk of the investments. Please refer to our latest market update to see the yield differentials for each credit rating.
2. High yield instruments will generally have more restrictive financial covenants set by lenders. Breach of the covenants could lead to an increase in the interest rate, triggering of additional fees, or even be considered an event of default (in which case the lenders may choose to take control of the assets to either replace the management team or sell the assets in order to recoup their principal).
3. Given the greater yield on high yield instruments, these bonds will experience greater volatility and sensitivity to movements in interest rate changes. From the lesson on the relationship between bond prices and yields (namely, they are inversely related), the magnitude of the impact of changing yields will be greater for riskier investments. This is measured by ‘duration’ and ‘convexity’ (we will discuss these in later posts).
4. The maturities of investment grade bonds are typically longer given the relative trustworthiness of the company.

Risk Management

There are generally two ways to incorporate credit ratings of bonds into risk management strategies.

First, for a portfolio of bonds, each individual bond will typically have an individual credit rating. Based on a weighted average approach, an investor can view the overall risk of the portfolio by calculating an assumed “portfolio credit rating.” There are two steps in this process.  

Assign an ordinal indicator to each credit rating category. For example, in the case of S&P credit ratings, we have assigned a figure to each credit rating category:

Next, we can find the assumed numerical weighting based on the credit rating of each bond. In the chart below, we have inserted random credit ratings to the dollar amount of each individual bond. Based on the weighted average of each portfolio position (dividing each holding amount by the total dollar amount held) and the numerical rating of each position, we can estimate the weighted average contribution in the “Weighted Avg Rating” column. After summing all of these rating contributions, we calculate a numerical rating of 3.8 for the portfolio. Looking back above at point 1, this implies a credit rating in between A and BBB.

The second way to incorporate credit ratings into risk management is by observing changes over time. Over time, as credit ratings increase or decrease, the investor can make adjustments to fine tune the portfolio. For example, in the case above, if the investor wants to keep a rating of A as the minimum for the portfolio, they may consider selling lower rated bonds (such as Bond 6, Bond 3, or Bond 4) and purchasing other bonds with higher credit ratings.

Total Return Perspective

One key element of utilizing credit ratings is to find potential cases where an investor believes a bond will receive a credit upgrade in the future. For example, a bond may be upgraded from a BBB to an A. Ratings upgrades occur when recent performance, the macroeconomic backdrop, or some other factor occurs and the credit rating agency determines it has materially lessened the company’s probability of default. For example, see the link here for a recent Moody’s upgrade of Anglo American.  

When this occurs, investors are willing to acquire the bond at a greater price given the risk reduction in the position. The key to this strategy is to predict when and if a company will experience a ratings upgrade. If an investor is successful with this strategy, they are able to lock in a higher return by selling the bond at a higher price than they acquired it for.

Summary

Credit ratings are an important component of risk management and bond investment strategy. Investors must be aware of various strategies they can deploy to take advantage of changes in the company’s rating. For example, a recent rating downgrade may provide an investor to take advantage of a lower price. However, the investor must be willing to either take on the additional risk or believe that some change will occur to reverse this trend sometime in the future.