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Fixed-Income Insights

A closer look at the credit-rating profiles of large-, mid-, and small-cap U.S. stock indexes may prove helpful for investors. 

 

In Brief

  • Many investors may be surprised to find that their equity portfolios contain the common stock of companies that have issued high-yield debt.
  • In the relatively high-quality, large-cap S&P 500® Index, 13% of the member companies with rated debt carried below-investment-grade ratings on their debt. Moving down the capitalization ladder, high-yield issuers find greater representation.
  • The percentage of below-investment-grade names among rated companies rises in the S&P MidCap 400® Index, and is higher still in the S&P SmallCap 600® Index. It should be noted, however, that large numbers of companies in both the S&P 400 and 600 are unrated.  
  • Understanding the ratings makeup of each capitalization tier may help investors better grasp the underlying credit exposure in each category.
  • The key takeaway: Regardless of an investor’s risk comfort level, an assessment of the underlying credit risk in a portfolio diversified across asset classes will better enable a portfolio to address goals as well as risk tolerance. 

 

It is not uncommon for “conservative” investors to shy away from the credit risk of below-investment-grade bonds (also known as high yield). Since the Great Recession of 2008–09, however, high yield has been among the best-performing sectors in U.S. fixed income, based on data from Bloomberg Barclays Indices.  What may surprise many reluctant investors of such bonds is that if they examine their equity portfolios, they may find that they own the common stock of many companies—including a number of well-known names—that have issued high-yield bonds.  Another interesting detail is that such investors may not realize that the equity of these companies is generally subordinate to debt in a company’s capital structure.

To examine the prevalence of high-yield issuers in key equity-market segments, let’s start at the top of the market-capitalization chain. The most widely followed measure of large-cap equities, the S&P 500® Index (S&P 500), generally displays stronger credit measures than are found in the larger universe of U.S. companies covered by the major credit rating agencies.  S&P Global reports that as of mid-2015, 87% of the rated companies in the S&P 500 were rated investment grade, compared with 44% of all rated U.S. companies.  This fact alone—that of all S&P-rated companies in the United States, more are rated below investment grade (56%) than investment grade (44%)—may surprise investors. 

Large Cap, High Yield
Yet even in the relatively high-quality, large-cap S&P 500, some 13% of rated companies carried below investment-grade ratings on their debt.  The ratio is essentially identical today.  As of March 31, 2017, 12.9% of rated companies in the S&P 500 had debt rated below investment grade.  These companies include names such as Netflix, Goodyear Tire & Rubber, Royal Caribbean International, Micron Technology, and Delta Air Lines.  There were a similar number of companies in the S&P 500 that carried no rating.  Some of these companies had debt, but it was not rated, while a few companies had no debt. 

For investors comfortable with the equity of these companies, below-investment-grade debt may be an investment worthy of consideration, depending upon a client’s risk appetite and the composition of the total portfolio. [Investments in equity and fixed-income securities carry different types of risk. See “A Note about Risk,” below.]

Mid-cap stocks may offer more persuasive consideration of high-yield securities.  As of March 31, 2017, according to S&P Global and FactSet, more than 37% of the S&P MidCap 400® Index (S&P 400) companies had debt that was unrated, leaving the balance of companies almost evenly split between debt-rated investment grade (31.6%) and below investment grade (31.1%).  Many companies in S&P 400 are not household names, often because they are not as large as companies in the S&P 500.  However, those that issue debt rated below investment grade include notable names like Sotheby’s, Time Inc., Avon Products, B/E Aerospace, Owens-Illinois, Avis Budget Group, and U.S. Steel. 

Comfort Levels
For investors with equity holdings in anything but the largest capitalization companies, it may be surprising how much exposure they have to companies with debt rated below investment grade.  If investors are comfortable with the credit of mid-sized companies, as represented by the S&P 400, exposure to high-yield securities may be less of a departure from their risk comfort zone than they believe. 

Alternatively, investors also may consider high-yield debt as a partial substitute for some equity exposure, if they feel stock valuations are excessive, or if they need more income.  (It’s worth noting that on a 20-year trailing basis through the end of 2016, the BofA Merrill Lynch U.S. High Yield Index actually displayed far less volatility, based on standard deviation, than the S&P 500.) Certainly, the risk/reward profiles of equity and high yield are different, but knowing the similarities in credit risk may help investors make a more informed decision when constructing a portfolio to meet their objectives.

Finally, it may be little surprise to find substantial high-yield exposure among small-cap stocks.  Unfortunately for credit comparison purposes, the small-cap universe is dominated by companies without debt ratings.  As of March 31, 2017, according to S&P Global and FactSet, 449, or 74%, of the 603 constituents in the S&P SmallCap 600® Index had no credit rating.

The remaining companies in the S&P 600 had debt credit ratings that were largely below investment grade.  Of the 154 companies with debt rated by S&P Global, 31 had debt rated investment grade, while 123 carried below investment-grade credit ratings. Such characteristics may be less of a surprise to investors who have reasonably large exposure to small-cap stocks.  Such investors are likely to be more comfortable with greater exposure to different kinds of risk, assuming they have consciously constructed their portfolio with risk in mind.

Summing Up
Regardless of an investor’s risk comfort level, understanding where credit risk resides in a portfolio diversified across asset classes will better enable an investor to address goals as well as risk tolerance.  As investors evaluate their needs for income, their total risk budget, and the valuation levels of stocks and bonds, this assessment of underlying credit risk will, hopefully, tilt the portfolio to better reflect all investment objectives.

 

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