Changing credit market makeup poses risks for rules based investing


Matthew Franklin, Credit Analyst

17 October 2018

Huge changes have been occurring in the sterling credit market in the decade since the financial crisis. One noticeable shift in the investment grade market has been the growing proportion of BBB rated credits, which has risen from just 12% in 2008 to over 37% now (see chart below). This huge transformation has occurred as corporates use ever more debt to support equity returns against a backdrop of anaemic growth, abetted by credit rating agencies willing to give higher levered borrowers’ investment grade ratings on the back of promises to de-lever in future. These BBB corporates have also taken advantage of low underlying government bond yields to lock in attractive long-term funding, issuing longer and longer dated bonds, with the duration of the BBB index increasing by close to a third from the lows in 2009.
Why should these trends worry credit investors? The last few years have also seen the growth of mechanical, buy and forget funds, using a set of rules on day one to build a fund supposed to last for the long term. However in an attempt to outperform, these pseudo passive strategies can be incentivised to tilt towards BBBs, treating credit as a commodity to achieve a yield target for a given rating framework; but the fundamental problem with this indiscriminate rating led approach is that not all BBB credits are equal. When some borrowers’ find themselves in difficulty they turn to the secured bank lending market, leaving bondholders in a junior position in a more levered business. Couple this with the increasing duration of the bond market, and the price impact for lenders can be eye watering. Add in the rigidity of rules based, rating driven investing, where investors are forced to sell the affected bonds once ratings finally catch up with reality, and clients can find themselves crystallising significant market losses when market technicals are at their weakest. 
So how can you avoid this BBB trap, particularly when historically over 5% of BBB credits are downgraded to sub investment grade each year? At RLAM, we don’t believe that BBB credit itself is the problem, but rather that investors need to be extremely selective in the way in which they lend to companies. Our long established credit research process focuses on the sustainability of bondholders’ lending position over time; by lending our clients’ money wherever possible with tangible protections such as security and covenants, and targeting our BBB exposure towards companies’ with more stable cash generation, we can have far higher conviction on how a borrowers’ balance sheet will evolve over time, as well as our position within it. 
With such huge and potentially under-appreciated shifts in the market make-up, and passive funds bound to its growing risks, our proven and active approach to portfolio construction has never been more relevant.
BoAML Sterling Non-Gilt index by rating

Huge changes have been occurring in the sterling credit market in the decade since the financial crisis. One noticeable shift in the investment grade market has been the growing proportion of BBB rated credits, which has risen from just 12% in 2008 to over 37% now (see chart below). This huge transformation has occurred as corporates use ever more debt to support equity returns against a backdrop of anaemic growth, abetted by credit rating agencies willing to give higher levered borrowers’ investment grade ratings on the back of promises to de-lever in future. These BBB corporates have also taken advantage of low underlying government bond yields to lock in attractive long-term funding, issuing longer and longer dated bonds, with the duration of the BBB index increasing by close to a third from the lows in 2009.

Why should these trends worry credit investors? The last few years have also seen the growth of mechanical, buy and forget funds, using a set of rules on day one to build a fund supposed to last for the long term. However in an attempt to outperform, these pseudo passive strategies can be incentivised to tilt towards BBBs, treating credit as a commodity to achieve a yield target for a given rating framework; but the fundamental problem with this indiscriminate rating led approach is that not all BBB credits are equal. When some borrowers’ find themselves in difficulty they turn to the secured bank lending market, leaving bondholders in a junior position in a more levered business. Couple this with the increasing duration of the bond market, and the price impact for lenders can be eye watering. Add in the rigidity of rules based, rating driven investing, where investors are forced to sell the affected bonds once ratings finally catch up with reality, and clients can find themselves crystallising significant market losses when market technicals are at their weakest. 

So how can you avoid this BBB trap, particularly when historically over 5% of BBB credits are downgraded to sub investment grade each year? At RLAM, we don’t believe that BBB credit itself is the problem, but rather that investors need to be extremely selective in the way in which they lend to companies. Our long established credit research process focuses on the sustainability of bondholders’ lending position over time; by lending our clients’ money wherever possible with tangible protections such as security and covenants, and targeting our BBB exposure towards companies’ with more stable cash generation, we can have far higher conviction on how a borrowers’ balance sheet will evolve over time, as well as our position within it. 

With such huge and potentially under-appreciated shifts in the market make-up, and passive funds bound to its growing risks, our proven and active approach to portfolio construction has never been more relevant.

BoAML Sterling Non-Gilt index by rating

Source: BoAML, RLAM. Chart shows breakdown of market since September 2008

Past performance is no guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.