Investors must adapt their fixed income strategies as
overall credit quality is set to fall in the coming years, according to Loomis
The proportion of AAA- and AA-rated bonds in broad bond
markets has fallen significantly in the past few decades, and there is no sign
of this trend reversing, said Chris Gootkind, director of credit research.
“In the early 1970s, more than 58% of the index was
rated AA+, while Baa was less than 10%,” he wrote. “Today, only AA+
is 20% while Baa is 44%.”
Only 13 US debt issuers are rated AAA, he added, and only
two of them have kept this rating since 1988—Exxon and Johnson & Johnson.
Gootkind illustrated a wider trend of falling credit
ratings: Since 1981, in only 11 of 34 full years did rating agencies upgrade
more issuers than they downgraded.
“There is really only one direction AA+ quality can
go—and that's down,” he wrote.
Gootkind gave several reasons for the long-term decline in
credit quality: falling central bank interest rates, low-cost debt, and the
rise of passive strategies leading investors to focus less on individual credit quality.
Lower-quality credit does not always mean investors are
fully compensated for the extra risk, Gootkind found. While total returns
increase on average when moving from AAA down to A, this does not always ring
true for high-yield bonds.
“High yield is a more mixed story, with lower-quality
credit (B and CCC) providing lower cumulative total returns relative to higher-quality credit (BB) over the past 20-plus yields,” Gootkind said.
However, he emphasized that, despite the overall downward
trend, default rates have continued to be cyclical rather than increasing.
To beat these conditions, Gootkind suggested investors should diversify holdings and “avoid a rigid,
rules-based approach, such as mandating average or minimum ratings, which can
hurt returns from forced selling.”
In addition, buy and hold approaches should be reassessed,
particularly with lower-quality bonds which could see their ratings change.
“Rather than relying on benchmark quality, consider
specifying investment percent by rating categories, consistent with your own
risk tolerance and return objectives,” he added.
"Credit market investors should bear in mind that
credit ratings are not static,” Gootkind concluded. “In making an
investment or structuring a portfolio, credit quality
migration—downward—should be expected and factored into one's investment
outlook, strategy, and return forecast.”
High Yield’s Liquidity Conundrum