Pity the poor credit analyst; tasked with forecasting the twists and turns of corporate borrowers far into the future in a world that has never felt more uncertain. Crystal ball gazing is challenging enough, but a recent paper from S&P provides further evidence of just how difficult it can really be.
The rating agency reviewed US corporate downgrades to BBB since 2010, and found that a majority of these were not due to deterioration in operating environment or trading performance, but rather the active choices of management teams.How frustrating it must be for a budding analyst to foresee the changing trends of an industry, only to be wrong footed by the idiosyncratic whim of a new CEO.
The S&P paper finds that a majority of downgrades to BBB by corporates since 2010 have been a result of management actions such as M&A or share buybacks. With anaemic growth, low interest rates, and equity focused incentives, perhaps it is of little surprise that executive teams would look to increase leverage to boost equity returns, adding to the growing proportion of bonds rated BBB (read more). And whilst the report focused on the US, we see this trend mirrored across markets, with BBBs tripling as a proportion of the sterling investment grade market since the financial crisis.
But why should the actions of profligate management teams matter beyond the reputations of a few ‘wrong footed’ analysts? Whilst not as significant as the move from investment grade to high yield, there is still a meaningful bond price impact as a credit moves from A to BBB, exacerbated by the typically longer-dated nature of bonds originally issued with higher ratings. In fact the price fall on downgrade has been exacerbated in recent years by growing regulation, such as Solvency II, with far higher capital charges for insurers holding BBB as opposed to A credit resulting in forced sales following downgrades.
So with a key driver of credit deterioration so difficult to predict, how do we approach credit analysis at RLAM? We start by acknowledging that there are limitations to analyst foresight, and that the bondholder friendly management team of today may not be there tomorrow once clients’ money has been lent. Instead of trying to gaze into a crystal ball, we focus our efforts on higher conviction areas, such as the protective benefits of security and covenants and an analysis on management incentives – a long-established approach to researching credit has never felt more relevant.
Past performance is not a reliable indicator of future results. 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. Portfolio holdings are subject to change, for information only and are not investment recommendations.