Credit Downgrades and How to Beat Them

There is far less top-quality fixed income around—and investors need to adapt, argues Loomis Sayles.

Investors must adapt their fixed income strategies as overall credit quality is set to fall in the coming years, according to Loomis Sayles.

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.”

Related:High Yield’s Liquidity Conundrum