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Investors seeking guidance for constructing their fixed-income portfolios are likely to find little help from credit ratings. Remember the rally in U.S. Treasury prices following Standard & Poor's August 5, 2011, downgrade of U.S. debt from 'AAA' to 'AA+'? If credit ratings were perceived by the market as an effective measure of repayment risk, however, Treasury prices would have declined.
More recently, the bond market swoon so far in 2013 reveals that higher quality credits (i.e., those with ratings above investment grade) have vastly underperformed credits of lower quality (below investment grade). For example, year to date through August 31, the BofA Merrill Lynch 10-Year U.S. Treasury Index and the Barclays U.S. Aggregate Bond Index (which is nearly three-quarters composed of high-grade government and agency securities) declined 6.8% and 2.8%, respectively, while the lower-quality BofA Merrill Lynch High Yield Master II and the Credit Suisse Leveraged Loan indexes rose 2.8% and 4.0%, respectively, according to Bloomberg data.
The bottom line is that investors relying on ratings as an indication of market risk and a predictor of price volatility have been, and will likely continue to be, disappointed.
Seeking Better Gauges
Market participants have, historically, placed a great degree of trust in these measures of creditworthiness. To be sure, the major credit rating agencies—Standard & Poor's, Moody's, and Fitch—emphasize that the ratings they issue are not indications of investment merit, or a measure of asset value. They are meant to be a gross summary of a bond issuer's ability to pay back principal and interest. But the fact that price movements in the high-yield market often precede ratings changes calls into question the ability of ratings to fulfill even this function in a timely manner.
Simply put, ratings are not an effective representation of risk or expected volatility. And, unlike the simplistic indicator many investors hope for, ratings cannot be used as a singular measure of risk.
If risk in fixed income is related to price movement, many other criteria may deserve consideration instead of ratings. For instance, supply and demand conditions have dominated fixed-income market movement in 2013. Fear that the supply of U.S. Treasury securities available in the market will increase as the Federal Reserve's quantitative easing purchases are reduced has had enormous impact on the prices of long-term, high-quality securities, as the index changes cited above indicate. At the same time, prices of lower-quality debt have held up much better.
The Fed Effect
An understanding of the speed of the reduction in Fed purchases, its timing, the effect of changes in Fed leadership, and the countervailing force of reduced supply of Treasury securities as the budget deficit narrows are all factors to be considered when evaluating the impact of reduced quantitative easing. In the meantime, as the Fed continues to anchor the benchmark fed funds rate at close to zero, the yield curve can steepen dramatically, creating other portfolio considerations and opportunities.
As yields rise and fall, other risks unfold. Securities that had been priced to reflect a call date ahead of their stated maturity may now trade to a much longer maturity date. Such maturity, or duration extension, particularly noticeable within mortgage-related securities, can have a meaningful impact on the volatility of fixed-income portfolios. Corporate and municipal bonds can also experience jumps in duration as prices move lower.
Effective portfolio management must go beyond credit analysis, supply projections, and yield curve expectations. Scrutiny needs to extend to the structure of individual securities and the change in volatility that may accompany a change in interest rates.
The Role of Inflation
Inflation is also a major factor influencing bond prices. It too can have a greater impact than credit ratings. The gradual decline in inflation over the past 30 years arguably has been a major contributor to lower interest rates and the secular bond rally during that time. Conversely, a significant increase in inflation could have a devastating effect on fixed-income portfolios.
However, inflation may not affect all bonds equally. The results of a 15-year study on inflation cited in a Forbes article, for example, expectedly reported a negative correlation between inflation and high-quality bond prices (as represented by the Barclays U.S. Aggregate Bond Index1). A negative correlation means that as inflation rises, bond prices fall.
However, surprising to some, the study also revealed that for the same period, leveraged loans and high-yield debt, both with lower credit ratings, had positive correlations with inflation. In fact, in both cases they featured stronger positive correlations than were found with Treasury Inflation-Protected Securities, a widely used inflation protection strategy.
A Fresh Approach
Investors clearly need to rethink their reliance on credit ratings while gauging risk. The assumption that lower quality means lower investment merit and increased price volatility can be erroneous and costly. Taking into consideration the myriad of influences other than credit is as important for individual investors as for professional portfolio managers.
As the economy continues its recovery, the Fed seems destined to unwind quantitative easing, eventually returning interest rates to more "normal" levels. That makes evaluating the appropriate criteria especially critical in order to properly position fixed-income portfolios. A rigorous, multifaceted approach to credit analysis—the kind that professional managers can provide—may be the best choice in an increasingly complex fixed-income market.
Risks to Consider: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may carry greater risks than higher-rated bonds. High-yield securities, sometimes called junk bonds, include increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Treasury Inflation-Protected Securities (TIPS) are Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.
Glossary of Terms
The Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index, and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.
The BofA Merrill Lynch 10-Year U.S. Treasury Yield Index is an unmanaged index tracking the 10-year component of U.S. Treasury securities.
The BofA Merrill Lynch High Yield Master II Constrained Index, which is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than 'BB-'/'Baa3,' but are not in default. The BofA Merrill Lynch U.S. High Yield Master II Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The CS Leveraged Loan Index is an unmanaged, trader-priced index that tracks leveraged loans. The CS Leveraged Loan Index, which includes reinvested dividends, has been taken from published sources.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.