Rating Changes Signal Balanced Credit Trends
Despite criticism for acting too slow or being backward looking, rating agencies and the credit ratings they assign are still relevant in the corporate bond market today. Ratings trends can be a useful, albeit imperfect, tool to access over credit quality in the market and sometimes offer a source of alpha if future ratings direction can be correctly anticipated. Non-financial credit ratings are based on fairly transparent criteria, particularly the leverage and profitability metrics. It’s the qualitative judgments about competitive position, industry dynamics and financial policy that are grey areas. While new issue ratings have proven to be an accurate gauge of default risk over time, the timing of subsequent ratings actions is a big market gripe. Ratings are meant to look through cycles, which can create big gaps between an issuer’s ratings and bond pricing and current fundamentals.
Trading aside, I think looking at the ratio of upgrades to downgrades does provide a decent high level view on the general state of credit quality. The chart above shows the ratio of upgrades to downgrades for all investment grade corporate bonds. While the ratio has declined over the past few years, it tells a story consistent with current moderate default rates and an overall benign credit environment. It also has remained above 1 since 2012, which is particularly impressive in light of the wave of energy and metals downgrades in 2015 and 2016. Many of the energy downgrades over the past few years have been due to merger and acquisition and other shareholder friendly activity, which reinforces the idea that event risk, as opposed to default risk, is the larger risk in the investment grade arena.
Ratings trajectory is one metric used to gauge credit quality in the marketplace. Given underlying business fundamentals and the potential for a number of commodity credits to be upgraded, the prospective upgrade/downgrade ratio appears like it will be trending up over the next year.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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