Bond Ratings Tell Only Part of the Story
Bonds with the same S&P or Moody’s credit rating can vary greatly in terms of their risk and subsequent return. New research shows that fixed income investors must also consider their credit spreads.
Wei Dai, Alan Hutchison and Samuel Wang contribute to the literature on fixed-income investing with their March 2020 study, “Credit Spreads, Rating Downgrades, and Downside Performance: A Market-Informed Approach to Monitoring Credit Risk.” They examined the credit risks in bonds with the same credit rating. Their data series covered fixed-rate U.S. corporate bond data from 1999 through 2018. They excluded bonds with options because their yields contain information about optionality as well as credit risk. Their resulting sample contained 1,270 unique issuers and 11,298 unique issues, and an average of 546 issuers and 2,665 issues per month. They classified bonds based on whether their credit spreads were above or below the midpoint between the spread curve for their stated credit rating and the spread curve for the next-lower credit rating. Following is a summary of their findings:
- There is a large dispersion in corporate bonds’ credit spreads conditional on the same credit rating – a sizable portion of bonds exhibit much higher credit spreads than same-rated peers (they have yields closer to those of lower-rated bonds). These bonds had a total market value outstanding of $144 billion as of December 2018, representing an economically meaningful portion of the corporate bond market.
- Credit spreads relative to those of peers – defined as bonds with the same stated credit rating – contain reliable information about future bond performance and credit migration.
- A greater distance between a bond’s credit spread and the midpoint reliably indicates a greater probability and a larger magnitude of a future downgrade in the next three to 12 months.
- Bonds with substantially higher credit spreads relative to those of their peers have higher rates of future downgrades. The above-midpoint group had an average downgrade frequency of 12.1%, 20.1% and 32.4% in the next three, six and 12 months, respectively, compared to 2.7%, 5.6% and 11.4% for the below-midpoint group.
- Bonds with considerably wider credit spreads behave more in line with bonds, with lower credit ratings in terms of average return, volatility and downside performance.
- Above-midpoint BBB-rated bonds underperformed the below-midpoint BBB-rated bonds by 46 basis points per month, on average, in months when the credit spread between investment-grade and high-yield bonds (i.e., between BBB and BB) widened. Confirming that there is information about credit risk reflected in the cross-section of spread, the average underperformance increased further when conditioned on months when the BB-minus-BBB credit spread widened by a larger amount.
- The annualized standard deviation of the above-midpoint BBB-rated group was 10.81%, more than double the standard deviation of the below-midpoint group, and the worst rolling one-year return was -30.27% for the above-midpoint BBB-rated group vs. -11.55% for the below-midpoint BBB-rated group.
Their findings led Dai, Hutchison and Wang to conclude: “Our results suggest that complementing stated credit ratings with real-time market price data can improve credit risk monitoring.” They added: “Our empirical results are not indicative of mispricing. Instead, they highlight the important role markets play in aggregating and disseminating information in real time.”
When investing in fixed-income markets, look beyond the credit rating. A credit-monitoring process that includes information from stated credit ratings and market prices provides a more complete representation of an issuer’s credit quality. Investors focusing only on the yields of bonds or on their rating will be underestimating risk.
Larry Swedroe is the chief research officer for Buckingham Wealth Partners.
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